U.S. Treasury Bond Yields: Are International Investors Crossing Into 'New Territory'?

 |  Includes: IEF
by: John M. Mason

On Wednesday I asked the question "Has the U.S. Treasury Bond Market Shifted?" A major part of this argument was that the yield on U.S. Treasury Inflation Adjusted (TIPS) bonds had risen significantly over the past couple of weeks and that it had closed above a negative twenty basis points for the first time in a very long time.

Well, yesterday, the yield on the 10-year TIPS closed above a negative ten basis points. We are getting very close to a zero yield on these securities, a level that I believe is a significant milestone.

Some journalists have heralded the rise in the yield of long-term U.S. Treasury bonds as a sign of a strengthening economy. Floyd Norris in the New York Times about "The worry is that economic growth may be about to accelerate."

The reason for this worry? "What matters is why interest rates are rising." Mr. Norris then quotes Robert Barbera, the co-director of the Center for Financial Economics at Johns Hopkins University, "In a world where bonds are getting killed because of inflation or mushrooming budget deficits, they will also kill stocks and home prices. If the proximate cause of a bond market sell-off now is that the trajectory of growth is a lot better, that is good news."

Mr. Norris, and many others are taking the rise in interest rates as "good news" because they believe that "the trajectory of growth is a lot better."

Certainly the numbers on real GDP growth this week should not cause one alarm. The revision of the GDP numbers for the first quarter show that the year-over-year rate of growth of the U.S. economy is still below 2.0 percent at 1.8 percent. The year-over-year rate of growth for 2012 was just 1.7 percent. Not much of a pickup.

Mr. Norris rests his case on the pickup in the rate at which housing prices are rising and the increase in consumer confidence. He added that the rise in interest rates is also another sign that the economy is picking up.

No mention is made that there has been a substantial shift in where international investors are placing their money. This was the subject of my blogpost on Wednesday. European financial markets, as well as the movements in the U.S. Treasury bond market support the argument that risk-averse funds are moving out of U.S. Treasuries and of German bunds, the two safe-haven investments over the past two years, and are moving into riskier assets.

This move to safety has been the primary explanation of why the yields on TIPS have been below zero for much of this time.

The fact that this yield is not approaching zero and possibly moving into positive territory is more of a signal that this risk-averse money is moving elsewhere, into Spanish debt, Italian debt, and Portuguese debt and not just because the U.S. economy is picking up. The yield spreads in European markets confirm this flow of funds.

The big problem is, as I mentioned on Wednesday, whether or not the European debt problems can really be pushed into the past. The eurozone economy is still in the pits. The rate of growth in the first three months of this year was a negative 0.2 percent. Unemployment in April rose to 12.2 percent, up from 12.1 percent in March. Youth unemployment was 24.4 percent.

Furthermore, the European Central Bank warned on Wednesday "that the eurozone's slumping economy and a surge in problem loans were raising the risk of a renewed banking crisis, even as overall pressures in the region's financial markets had receded." Jack Ewing in the New York Times goes on: "In a sober assessment of the state of the zone's financial system, the central bank said that a prolonged recession had made it harder for many borrowers to repay their loans, burdening banks that had still not finished repairing the damage caused by the 2008 financial crisis."

To paraphrase Yogi Berra, it seems as if the crisis is not over until it is over. The deeper problem is that Europe just cannot get its act in order. And, the problem is political and not economic. The eurozone is 17 countries. It is not one governing body.

The justification for the creation of the eurozone was primarily an economic one. A monetary union that integrated the economies of the many countries joining the union would be beneficial to all of the countries. And, it has been.

Yet, as Princeton historian Harold James suggested last week, when "growth falters", when conflicts about income/wealth distribution arise, "the credibility of the project crumbles." There is very little incentive for the various parties within the union to compromise their sovereignty and submit to the "good of the whole."

Mr. James has written a lot on the European Union and the efforts to build a common monetary bond between the countries. But, Mr. James still sees the current situation as one in which the cart was put before the horse. In Munich last week, he argued that trying to put together the economic union before the political union was the wrong way to create a viable long run structure. Without the political union, little long-term agreement can be achieved on the sticky economic questions.

He writes: "Case in point: With the immediate financial market pressure lifted, EU leaders traveled to Brussels this week and ignored the challenges to the currency union, instead preferring to discuss tax evasion and energy polity."

Going on he concludes, "There is a lack of popular enthusiasm for the project and little attempt to justify it beyond the economic." That is, the trouble is not over.

Therefore, I continue to argue: Watch the yield on the 10-year TIPS. I believe that this has been, and will continue to be in the near future, an indicator of where the risk-averse international money is going. If this yield goes through zero into positive territory then this will show that the international investment community continues to gain confidence that things are "OK" in Europe. Then we will see the yield on U.S. Treasury securities continue to rise, but not necessarily because on the increasing strength of the United States economy. As I state in the earlier post, the yield on the 10-year U.S. Treasury bond could rise into the 3.00 percent to 3.5 percent range.

However, if the yield on the 10-year TIPS remains in negative territory and even goes more negative, this would be an indication that investor concern over the European situation has not gone away.

To me, this is not the call of the Federal Reserve, nor does it say anything about the strength of the U.S. economy. This latter case is primarily one of risk aversion on the international scale.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.