Bond Markets: Reach Across The Pond

by: Rodney Johnson


The Fed is tapering its bond buying and could end the practice altogether. Prices should ease in theory, but what if other buyers just took its place?

The ECB has instituted a punitive interest rate of -0.1% on excess deposits. To avoid the penalty, they could withdraw and invest in safer assets.

Given that high-quality bond in the euro zone are trading just over 1%, U.S. government debt seems like a juicy target.

For six years, investors have been stuck with exceptionally low interest rates in U.S. markets.

Currently, 10-year U.S. Treasury bonds yield a paltry 2.5%. Buying these bonds with inflation sitting around 2% is like giving the government free money. Their real cost (yield minus inflation, or 2.5% minus 2%), is almost zero.

Many analysts have called for higher rates, particularly since the Fed is tapering its bond buying and could end the practice altogether in October. Without this mega-buyer in the marketplace, the pressure on prices should ease, leading to higher yields. It's a great theory, but what if it doesn't work?

What if, instead of a vacuum being created when the Fed steps away, other buyers jump up to take its place?

It might sound crazy, given the low yields on U.S. Treasuries, but there are many buyers out there who are offered even less return on their money… and most of them are in Europe.

While the U.S. 10-year Treasury bond sports a yawn-inducing 2.5% yield, the Spanish 10-year bond is roughly the same, whereas the Italian 10-year bond pays a whopping 2.7%.

The difference is that these two countries are in economic shambles. They might not be able to repay their government loans and they don't have the ability to print more euros to inflate their way out of debt.

If we look at the strong men of Europe, Germany's 10-year bond pays less than half of U.S. rates, at 1.13%, while French 10-year bonds pay 1.54%. Talk about stingy rates!

The trend throughout Europe is clear. Strong countries pay exceptionally low interest rates, while questionable countries pay just a bit more. The Netherlands pay 1.34% on their 10-year bonds, Britain 2.55%, Switzerland 0.49%, Greece 5.73%, and Portugal 3.56%.

All of this reflects the same trend - low inflation, and even a fear of deflation. In such an environment, investors begin to channel Will Rogers, claiming: "We're more interested in the return of our money, than the return on our money."

Given the continued weakness in many of the countries in the euro zone, it's logical that their interest rates are exceptionally low, but that doesn't mean investors in the region have no choice. If they're interested in buying the debt of a relatively strong country and want higher yield, they can always reach across the pond.

Now that the euro has shown some weakness against the U.S. dollar, it could be the perfect time for European investors to step in and take the place of the Fed. If the trend continues, European investors that buy U.S. dollar-denominated bonds could make money on both the interest earned and the movement of currency markets.

Making this even more attractive is the fact that the European Central Bank (ECB) has instituted a punitive interest rate of negative 0.1% on excess deposits at the central bank. If banks don't find qualified borrowers, they'll have to either pay the penalty or withdraw the funds and invest in relatively safe assets.

With a European economic recovery nowhere in sight, and high-quality bonds in the euro zone trading just over 1%, U.S. government debt must seem like a juicy target. But if bond buyers on the continent want to take advantage of the situation, they should hurry.

Any drop in economic activity in the U.S. could take our own 10-year Treasury bond below 2%. Then we'd be just one more big country paying almost nothing to borrow money, and U.S. investors would be struggling with even less income.

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. The author has no business relationship with any company whose stock is mentioned in this article.