The mounting economic uncertainty emanating out of Europe has again increased the demand from global investors for ultra high quality assets. This flight to quality bid from investors has pushed a host of sovereign bond yields to record lows. According to Global Financial Data, the U.S. 10-year bond yield has eclipsed its previous 1946 low and the British 10-year borrowing rate hit its lowest level since data began being tracked in 1703. Germany saw its 10-yr bund hit a fresh all time low as well, but more notably the 2-yr bund traded down to a zero yield, which means investors would rather hand the German government their euros for two years and earn nothing on their money than lend it anywhere else in the European economy.
While U.S. yields are setting new records, relative to other safe haven government bonds, the benchmark U.S. Treasury security seems fairly priced when compared to its similarly rated peers. Below is a listing of the 10-yr bond yields from the world's sovereigns who carry at least two AAA ratings from the three major nationally recognized statistical ratings organizations:
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Source: Bloomberg; close of U.S. business 5/31/12
Of course, the safe haven nature of these assets is not the only factor affecting relative yields. Australia boasts the highest yield given the country's relatively high rate of inflation as the export driven economy imports inflation from its Asian trading partners. Slower growth economies where inflation is expected to remain benign, all else equal, should expect to carry lower nominal interest rates because investors do not need to be compensated for inflationary effects. France boasts the second highest yield. While the country remains highly rated, some market participants have ascribed increased credit risk to the nation's sovereign due to the potential need for the country to need to recapitalize its banking system in the event of a European financial contagion. France's 5-yr credit default swap spreads at 220 basis points trade more like the default risk of mid to low BBB credits Whirlpool (WHR) at 230, Xerox (XRX) at 235, or recently investment grade Ford (F) at 250. Excluding Australia and France as outliers, U.S. Treasury bonds, despite their all-time low yields, appear to be relatively attractive to the remaining AAA basket.
The United States has historically been the flight to quality destination given the reserve currency status of the dollar and the previously unmatched opinion of the nation's credit quality. As the U.S. government has continued to run budget deficits, and its national debt continues to resultantly increase, perhaps this designation has lost its permanence. This raises the interesting question as to whether U.S. Treasury securities are priced appropriately to their AAA brethren.
Another interesting observation to determine the appropriate relative valuation of Treasury securities can be seen in the decoupling of Treasury yields and domestic equity returns. On May 20, 2011, just over one year ago, the yield on the ten year U.S. Treasury closed at 3.15%, double the current yield. The S&P 500 Index (SPY, IVV) closed that day at 1333. While global financial system stress and slowing economic growth in the United States have led to a historic rally in Treasury securities, the domestic equity market is essentially flat. One of these markets, government bonds or stocks, is likely wrong, and only time will tell which market move proved prescient over the past year.
Accommodative monetary policy from global central banks has made the financial world awash in liquidity. Euros will need to be moved from German two-year government securities paying zero and over to Italian and Spanish sovereigns and banks. Historically, financial markets have been the clearing mechanism for this movement, paying investors for this incremental risk, but the European financial system appears far from being this mechanism without further supranational policy intervention.
Whether the stability of U.S. equities can persist will be dependent on whether both dollars and euros can find the appropriate landing spots. If this process materializes successfully and crisis is averted, equities will outperform safe haven bonds in a pattern similar to the first quarter of 2012, but if market jitters grow into a panic, safe haven yields will continue their march towards zero, and global equity and credit markets will correct more sharply than what we have witnessed thus far. I remain in the former camp, but near-term market outcomes are becoming more divergent.