As regular readers of this blog know, I believe that most of the recent movement in the yields of longer-term US Treasury issues has been due to a substantial flow of out of these Treasury securities into other, "riskier" debt elsewhere in the world, primarily in Europe.
These monies flowed into the United States over the past few years attempting to find rest in securities that faced less credit risk than was to perceived to exist on the European continent. These flows resulted in an extraordinary decline in the yields on inflation-linked Treasury bonds, which even went negative for an extended period of time. The yields on non-inflation-linked Treasuries also declined in a parallel fashion.
Since the middle of May these flows have been reversed and the yields on longer-term Treasury securities have risen. That is, the prices on these longer-term issues have fallen a good deal. The interesting thing is that the prices on these so-called risk free Treasury issues have fallen by much more than have the prices of other fixed-income securities.
James Mackintosh, writing "The Short View" column in the Financial Times, tells us:
"Not only have U.S. 10-year Treasury bonds lost almost 10 percent since taper talk started in May, they have also been beaten by U.S. investment grade corporate bonds (down 6 percent) and by junk bonds (down 2.5 percent).
Look in more detail, and the inversion is even clearer: the higher the credit rating of a bond, the bigger the loss-with the lowest-rated junk only just losing money, according to Barclays' indices."
Mackintosh, however, relates this disparate movement to the interest rate cycle. The interest rate cycle may help to explain part of this particular movement but the connection of the rise in U.S. Treasury yields with changes in yields on European sovereign debt do more to explain the move than does just the interest rate cycle.
First of all, not all the risk-averse money left Europe, as another refuge for funds was German bunds. In early May the yield on 10-year German securities was below 1.20 percent. The drop in the yield on these securities over the past few years closely paralleled the fall in the yield on the 10-year Treasury bond.
As money began to flow out of European sovereign debt in May, the yield on the German bonds rose as did the yield on the Treasury securities. By the middle of August, the yield on the 10-year German bund was around 1.90 percent, almost a 60 percent increase.
But, the yield spreads on other European sovereign debt fell, especially those related to the securities of the more troubled countries. In many of these countries the actual level of yields also fell.
For example, the yield spread between the German 10-year bond and the 10-year Greek bond feel from around 1,000 basis points in early May to under 800 basis points in the middle of August. The spread between the German rate and the rate on Portuguese bonds dropped from just under 500 basis points at the earlier time to under 450 basis points in recent trading.
Note that the yield on the Greek bonds bounced up yesterday as news came out of the German election process that Greece might need a third bailout.
The point is that the major money flows over the past four months have been related to the rising confidence in the safety of European sovereign debt and these flows have resulted in the rise of yields on both German sovereign debt and U.S. Treasury securities. These latter securities have been assumed to be the most risk-free securities around.
Since the money flowing into U.S. Treasuries were connected with credit risk, the funds went more into government issues and not as much into U.S. investment grade corporate bonds or into junk bonds. Thus, we get the results that Mr. Mackintosh reported.
Interest rates rose on all these bond issues, but, the U.S. Treasury market lost relatively more funds than did the corporate market, either for investment grade securities or for junk issues. But, this leads into another issue: what might happen to the bond market going forward into the fall?
Mohamed El-Erian, Chief Executive and Co-chief Investment Officer of PIMCO, addresses this in his recent column in the Financial Times, "Don't Wait Until Autumn to Reposition Portfolios." To Mr. El-Erian, as one looks toward the fall of the year, one sees a substantial amount of uncertainty. And, this uncertainty is seen not only in the timing of Federal Reserve tapering, but also in the selection of a new Federal Reserve Chairman. And, the uncertainty extends to Europe, Japan, and the Middle East.
And Mr. El-Erian writes, as the title of his column suggests, that investors in the bond markets better not wait until the fall comes to consider making adjustments to their bond portfolios. Better to do it now, even though markets might be a little thin due to August vacations, than to move in the face of possible market turmoil after Labor Day.
He closes with this:
"Wherever you look at it, a long list of uncertainties is building up as the summer comes to an end. And, it consists of factors that are not easily resolved by the tepid endogenous healing of the global economy-all of which points to quite a bit of autumn market volatility."
At this time, I don't have anything more to add to the discussion.