Dollar Flow Points To Higher U.S. Long-Term Interest Rates

Includes: IEF, TLT
by: John M. Mason

In a recent post, I emphasized the role that the flow of international money from the United States was having on the yields of longer-term U.S. interest rates.

The argument is that international investors, during the recent European financial crisis, had moved "risk-averse" funds to the United States and this had contributed to very low long-term interest rates, especially to negative yields on U.S. Treasury inflation-protected issues. This spring, as confidence rose in the eurozone's efforts to resolve its financial problems, funds flowed out of the United States and back to Europe resulting in the yields on the inflation-protected securities moving into positive territory and causing yields on all longer-term Treasury issues to rise.

More evidence is surfacing that this flow of funds is serious and is an indication that the financial crisis in the eurozone is lessening. I do not mean to imply that Europe has resolved its crisis situation and is "out-of-the-woods" in terms of moving smoothly into a new future. Officials in Europe still have many issues that remain to be worked out and there is still plenty of problem-areas that could cause future concern over the existence of the euro. That is, there remains the possibility that risk-averse funds could once-again flow back out of Europe and into the "safe-haven" of U.S. financial markets.

One such piece of evidence is that money market funds in the United States have moved substantial amounts of funds back into European banks. Christopher Thompson writes in the Financial Times :

"U.S. money market funds have nearly doubled their allocations to European banks over the past 12 months is a sign of improving investor sentiment towards the region.

That represents an increase of nearly 90 percent since June 2012 when fears over a eurozone break-up were at their peak.

U.S. money market funds have traditionally been a key source of short-term dollar funding for banks across Europe. But in 2011 they were among the first big investors to withdraw money as the crisis in the eurozone escalated."

In other news, Moody's released information that the acquisition of subordinated debt issued by banks in the eurozone increased from $15.2 billion in the first half of 2012 to $52.2 billion in the first half of 2013. Stephen Foley also writes in the Financial Times:

"Investors are showing renewed appetite for riskier bank debt as the industry's new regulatory regimes take shape and the eurozone crisis recedes."

Furthermore, he writes that 'The extra cost of insuring subordinated debt through credit default swaps, versus senior debt, is at its lowest level since 2010."

Foley continues, "About one-third of European subordinated debt will count towards Basel capital requirements, Moody's estimates, making it a useful tool in repairing balance sheets damaged by exposure to weak sovereign and mortgage credits."

Good news for Europe. Not so good news for yields on U.S. government debt as continuing flows of funds out of the United States will tend to cause Treasury longer-term yields to rise.

Funds flowing out of the United States for the reasons mentioned above will not necessarily be good news for the value of the United States dollar. This flow of funds tends to counter-act the debates over Federal Reserve "tapering" of its open-market purchases of Treasury issues and mortgage-backed securities.

Over the past two months or so, we saw the value of the U.S. dollar rise as Mr. Bernanke and the Federal Reserve gave signals that maybe the Fed's purchase of securities might "taper" off. Once Mr. Bernanke and others within the Federal Reserve backed off of these "signals" the value of the dollar declined once again.

That is, the flow of funds from the "safe haven" of United States Treasury securities came to dominate foreign exchange markets causing the value of the dollar to sink modestly.

Thus it seems as if the value of the U.S. dollar will tend to remain weak in the near term because the flow of funds will continue to favor "riskier" debt over "safe-haven" debt.

In terms of the future of longer-term interest rates in the United States, I believe that the flow of funds will continue to return to the eurozone … and other "riskier" areas. In fact, as confidence builds the flow might even increase. If the flow were to increase, I would expect the yields on longer-term Treasury issues to rise at a faster pace than presented in the post mentioned in the first sentence of this writing. And, the Federal Reserve will not be able to stop this rise.

Of course, if eurozone financial markets tank again … all bets are off.

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.