Something has happened in the government bond markets over the past three weeks! Is this the "risk off" movement of funds that I and a lot of other investors have been looking for?
In the first week of May the yield on 10-year U.S. Treasury Inflation Adjusted (TIPS) bonds were trading was between a negative 50 basis points and a negative 70 basis points. Yesterday, this yield closed at a negative 0.192, the first time the yield has been above a negative 20 basis points since April 2012.
The TIPS yield dropped into negative territory for the first time in the August/September 2011 period and has remained there ever since. The interpretation given to this negative yield is that international investors were using U.S. Treasury bonds as an escape from the riskiness of other sovereign debt, especially that of Europe.
The only other "safe haven" for those investors avoiding credit risk being the German bund whose yield reached a low of around a positive 1.20 percent in the first part of May 2013. The yield on the 10-year German bund closed above 1.50 percent yesterday.
Thus, as international investors showed concern over the riskiness of, particularly, the sovereign debt of much of Europe, they moved their "risk averse" money to the United States bond market … and also into German bunds. Anytime some confidence was regained in European debt, the yields on TIPS and 10-year German bunds rose. Now we see a rise of 30 basis points or more in these yields over the past three weeks.
Could the market be moving into a "risk off" stance? To me this is the first thing that needs to happen for the financial markets to regain some "normalcy." It is what I have been looking for over the past two years.
To me, the yield on the 10-year TIPS needs to rise through zero and then move into the one percent range. If the yield does this, then I would argue that international investors were returning to a more "normal" perception of risk allocation in the world. That is, the international investors would be indicating that they believed that the financial crisis in Europe was over. That they, the international investor, could fell relatively safe in investing in Greece again … and Italy … and Spain.
Of course, this is the big assumption. However, they seem to be putting their money to work in this way. Not only has the yield on the 10-year German bund risen by about 30 basis points over the past three weeks, the yield spreads on European sovereign debt have reached recent lows.
For example the yield spread between the 10-year Greek bond and the 10-year German bund was in the low 700 basis points. At the end of April, this spread was over 1,000 basis points. The spread between Italian bonds and the German bond dropped to about 250 basis points yesterday. About six weeks ago, this spread was over 300 basis points. The same movements have occurred in the yield spreads on Spanish bonds and Portuguese bonds and the German bund.
Like I wrote earlier, the assumption that the European debt situation is over is a BIG assumption. Right now, an awful lot of faith is being put on the European Central Bank. The ability of other European leaders to lead is still questionable.
But, that is the way the money seems to be flowing at this particular time. The other interesting component to this movement in government bond yields is that the relationships in the United States bond market continue to hold.
For example, a measure of inflationary expectations, the difference between the yield on the 10-year U.S. Treasury bond and the yield on the 10-year TIPS continues to remain relatively constant at around 2.40 percent. Investors in U.S. Treasury securities seem to be assuming that the annual rate of inflation in the United States over the next ten years will be around 2.40 percent.
This "expectation" is a little lower than it has been over the past year or so … the average has been in the 2.50 percent to 2.60 percent range … but given the sluggishness of the U.S. economy this might be expected.
The point is that the spread between the yield on the 10-year Treasury bond and the yield on the 10-year TIPS has been relatively constant throughout the past two years. In other words, the movement of risk averse funds into U.S. Treasury bonds and out of U.S. Treasury bonds has been resulted in these two yields to move in a parallel path. This result gives me some confidence that my interpretation of these fund movements is roughly correct.
Therefore, if the movement of "risk averse" funds continues out of the U.S. Treasury bond market and the yield on the 10-year TIPS moves into the positive 1.00 percent range, the 10-year U.S. Treasury bond should be trading in the neighborhood of 3.50 percent, up from about 2.20 percent where it closed yesterday.
Note that this movement in the yields of U.S. Treasury securities has nothing to do with any pressures on interest rates that might come about due to a firming up of economic growth. This movement is just associated with the massive movement of funds we have experienced because of the "risk on" and "risk off" flow of funds due to the risk aversion of international investors.
Let me also add, that this movement depends upon the belief on the part of these international investors that the situation in Europe is stabilizing … the worst part of the recent financial crisis is over. This, as I wrote earlier, is a BIG assumption. I will write more on this tomorrow.
For now let me say that it is encouraging that international funds seem to be leaving the "safe havens" of the United States and Germany. One hopes that these international money managers are correct. However, I would still keep nimble and be prepared for the "risk off" flows to stop and reverse themselves once again. I am not quite convinced that the "play" is over yet.