The Next Known Unknown - Europe?

Includes: IEF, IPE, TIP
by: John M. Mason

Longer-term interest rates in the United States have been rising. The argument I have been making is that this rise is due to the relatively "calm" financial markets in Europe.

My argument has been that about two years ago, in the first six months of 2011, concern about sovereign debt issues of peripheral European countries took center stage. As a consequence of this concern, international investors sought to get out of this European debt and move their funds into "safe havens", the government bonds of countries that seemed to exhibit the least amount of risk at that time. As a consequence, lots and lots of money moved into US Treasury securities and German bunds.

An interesting result of this movement of funds was that the yield on US Treasury-issued inflation-adjusted securities (with a 10-year maturity) dropped below zero. In September 2011, the yield on the 10-year TIPS dropped below zero for the first time ever. After dropping below zero a couple more times in the fall, this yield fell below zero in November 2011 and remained below zero until last Friday, June 7, 2013.

The variability of the yield on TIPS seemed to be correlated with events going on in the eurozone with respect to the efforts to bring governmental budgets under control. If it seemed as if the European Union was making some progress in taming the fiscal problems of the weaker European states then some money seemed to flow back into European financial markets…and the yield on the TIPS moved closer to zero.

If the EU seems to be splitting on these fiscal problems, money flowed back into the "safe havens" and the yield on TIPS became more negative.

Early this spring, international investors seemed to exhibit growing confidence that the European situation was getting better and funds began to move back into the sovereign debt of the weaker peripheral countries Spain, Italy, Greece and Portugal. The spreads between the yields on this sovereign debt and that of Germany…and the United States…fell dramatically as this confidence grew.

In April, "Foreign investors sold long-term U.S. Treasurys in record amounts in April" reports the Wall Street Journal. "The sales mark a reversal after several years in which investors around the globe plowed money into U.S. Treasurys as a safe-harbor investment. The flows helped push Treasury yields to record lows in recent years…"

In May, the yield on the 10-year TIPS became less and less negative until last Friday when the yield moved into positive territory. It has remained in positive territory for a week now as it closed to yield 0.024 on Friday June 14.

I have argued that if things stay calm in Europe, it is possible that the yield on the 10-year TIPS could rise to about a positive 1.00 percent, a level this bond was trading at for the last half of 2010 and the first half of 2011, before the European situation took over.

Given that the regular 10-year US Treasury bond has been trading at about 210 to 240 basis points above the yield on the 10-year TIPS, I have been predicting that the yield on the regular 10-year US Treasury bond could be trading in the range of 3.10 percent to 3.40 percent by the end of this year. That is up from the 1.60 percent to 1.70 percent range the 10-year bond had been trading in earlier this year.

The big question mark in this picture is the European scene. If the European officials can hold things together in a way that international investors can continue to feel confident that the worst of the financial crisis is over, then I will stick with my forecast of the yield on the 10-year Treasury issue.

However, if the European situation "falls apart"…if the European officials are seen as failing in their attempts to resolve the fiscal issues in the eurozone, then I will back off of my forecast and will argue that the yield on longer-term US Treasury securities will fall back to levels seen earlier this year.

This latter scenario seems to be a concern of Charles Forelle and Marcus Walker in the Wall Street Journal on Friday June 14: "Euro-Zone Risks Return to the Fore".

The article begins:

"The recent turbulence rattling global bond markets is unmasking an unpleasant notion in Europe: The eurozone's problems aren't solved.

Government bonds have recently taken a hit around the world, now that investors are preparing for the possible end of central banks' boundless economic stimulus. And those bonds of the weakest eurozone countries have shown some of the biggest drops.

That suggests that the bonds of Spain, Italy, Portugal, and Greece might be susceptible to bigger swings in the future, as the flood of cash that has poured into financial markets recedes, leaving their economic warts exposed…."

In other words, there is a dark cloud still hanging over international financial markets…a dark cloud that still contains doubts about whether or not European officials have really solved the structural problems that exist on the continent.

But, Forelle and Walker argue, there is a large problem that still has to be overcome:

"In order to restore their viability, weaker countries must improve their industries' competitiveness by pushing down wages and other costs, relative to Germany and other northern countries. But the German economy appears to have settled into a pattern of low growth and low inflation.

That means Italy, Spain, and the others need more of this so-called internal devaluation. And devaluation makes it harder to pay down debt."

That is, much of the European continent still has to go through a structural realignment before the financial crisis will really come to a close. And, this structural realignment still has a long ways to go.

Well, there it is…the dark cloud on the horizon. Europe is the known unknown.

Will international money stay in Europe with the result that the yield on the 10-year US Treasury will rise to 3.00 percent or more? Or, will the European financial crisis be extended with international money flowing once more back into the "safe havens" of the world?

How are you betting?

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.