What's Going On? Still A Flight To Safety In Major Bond Markets?

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


The yield on the 10-year German Bond has reached an all time low. This has surprised investors in Europe.

The yield on the 10-year US Treasury Note has dropped this year. This has surprised investors in America.

Risk factors do not seem to explain this situation. Maybe changes in expectations about economic growth in the two regions are an explanation.

Today, the yield on the 10-year German Bond hit an all time low. The bund yield reached 1.119 percent, which was below the previous record of 1.127 percent, achieved in June 2012. The previous record was set during the peak of the eurozone crisis that involved Greece, Spain, and Italy.

What is going on?

Interest rates, including German interest rates, had been expected to rise this year. On December 31, 2013, the yield on the 10-year bond was 1.94 percent. Forecasters expected the yield would rise during the end and close out 2014 around 2.30 percent.

Funny thing. The yield on the 10-year United States Treasury note has followed a similar pattern during the year. On December 31, 2013, the 10-year Treasury closed to yield 3.04 percent.

Most analysts, myself included, expected this rate to go up through the year and close at least around 3.50 percent.

Well, yesterday, the 10-year closed to yield 2.486 percent.

This yield is not even close to the lows, around 1.50 percent, hit in June and July of 2012.

Wait a minute! The record low yields in the United States came at the same time that the yield on the 10-year German Bund hit its previous low!

Yes, that's right. In the summer of 2012, as the financial crisis took place in Europe, risk averse monies fled to the "safest havens" around…Germany and the United States.

It is interesting to review data from that time period because it is apparent the safety was such an important characteristic of the money flows that the funds pouring into the United States from Europe took the yield on the United States Treasury Inflation-Protected securities (TIPS) into negative territory. For example in June and July, the yield on the 10-year TIPS fell to the NEGATIVE 0.6 percent to 0.7 percent range.

This was not the lowest yield achieved. In December 2012, the TIPS yield got down to around a NEGATIVE 0.9 percent level!

There was a lot of investment money that was very, very scared at that time!

The difference is that in June and July of 2012 United States Treasury bonds and German bunds were the safe havens that investors were flocking to. We can see this in the spreads between the yield on the German 10-year bund and the yields of the bonds of other countries. The 10-year bonds of the Spanish government were yielding more than 500 basis points over the yield on the 10-year German bund. Italian 10-year bonds were yielding 450 basis points more. In Portugal, the yield was more than 1,000 basis points over the German yield. And, Greek 10-year securities were yielding more than 2,500 basis points than the German equivalent.

Today, you do not see these spreads. The spreads over the German 10-year bund at the close of business yesterday were as follows: Spain, 134 basis points; Italy, 152 basis points; Portugal, 242 basis points; and Greece, 470 basis points.

There still may be some risk-averse monies from these latter countries in both the United States and in Germany, but in my opinion, the major reasons for the low rates in the US and Germany must be found elsewhere.

The primary reason for the low rates of growth may be the low expectations for economic growth in the two countries.

If one assumes, as I do, that the nominal interest rates is composed of two factors, the expected real rate of interest, which many economists equate with the expected real rate of growth of the economy, and expected inflation, then we can develop a rational for the low rates and the difference in the rates.

Germany is in the eurozone and the eurozone is going through a period of disinflation and possible deflation. Needless to say expected economic growth is low and below that of the United States. And, expectations for future economic growth were revised downwards in the first half of this year.

This can account for the low yield on the German bunds and for the revision downward in the interest rate forecast for the year as analysts came to expect that the European growth rates were going to be lower this year than had been expected as late as the fourth quarter of 2013.

The same picture can be drawn about interest rates in the United States. Toward the end of last year, the United States economy was expected to grow around 3.0 percent, year-over-year. With the disappointing first quarter, the expected growth rate was revised downwards in the April and May period.

An interesting fact is that the yield on the 10-year TIPS closed at 0.777 percent on December 31, 2013. In May 2013, the yield dropped below 0.300 percent. Yesterday, the 10-year yield closed at 0.204 percent.

If one assumes that TIPS are a proxy for the real rate of interest and that expectations about the real rate of interest are tied to the expected real rate of growth of the economy, then the movements in the yield on the 10-year TIPS coincided very closely with analysts changes in expectations on the real rate of growth of the United States economy.

So, what is going on in the major bond safe-havens in the world?

Well, it looks as if the "surprises" in bond yields this year have not been a result of investors flocking to the safe-haven securities of the world.

What appears to be happening is that bond investors have realized that the pace of economic growth in Germany and the eurozone, and in the United States, are not what was expected toward the end of last year and have subsequently reduced their belief in what the level of interest rates should be.

Note, that the movements we have been talking about are in the longer-end of the bond market. Furthermore, note that the explanation for these movements have not considered the actions of the Federal Reserve or the European Central Bank. This is consistent with the viewpoint that longer-term interest rates are less under the influence of central banks than they are of basic economic forces. I think that we need to take this point into consideration when we analyze the impact that the end of Federal Reserve "tapering" and the potential efforts on the part of the Federal Reserve to raise short-term interest rates will have on these longer-term interest rates.

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