The US Bond Market and the Situation in the Eurozone

In my last post, I wrote about the bond market in the United States and how the European situation is impacting the structure of yields in US financial markets.  My conclusion was that the “flight to quality” being experienced in world financial markets has led to a situation in which the supply of funds to United States financial markets has resulted is extremely low long-term interest rates and a negative yield on the US Treasuries inflation-adjusted securities (TIPS). (http://seekingalpha.com/article/551121-what-are-the-bond-markets-trying-to-tell-us) 

The question then becomes, if the extremely low long-term interest rates are a consequence of a “flight” of funds from European markets and this condition will last in some form until the European Union “gets it act in order” what will be a condition of Europe “getting its act in order”?

Over the past two years or so the efforts of the European Union to resolve the sovereign debt crisis has “kindly” been referred to as “kicking the can down the road.”  No one seemingly wants to “get their hands around the situation” and work to resolve the crisis.  Consequently, the crisis lingers on with recurrent bouts of national concern like that now being focused on Spain. 

It should be obvious by now that “kicking the can down the road” is not going to end the sovereign debt crisis in Europe. 

The current direction in which European elections are headed seems, if anything, a step backward in the process.  But, Europeans are tired of all the austerity.  They want to throw existing policymakers out of office and elect someone else…it doesn’t really seem to matter who.  And, we are seeing this played out in this weekend’s elections in France and Greece.  This following the situation in the Netherlands where the existing government was defeated, the 10^th such government to lose power since the debt crisis began.  

Tom Sargent, an economist who won the Nobel Prize last year, suggested in his Nobel Prize winning acceptance speech that the current problems being faced by the nations of the eurozone are similar to those faced by the United States as it was trying to become a unified country in the late 18^th century.  The European Union now is like the US under the Articles of Confederation at that time.  The US had to become a unified country under a Constitution and establish its fiscal credibility before it could operate as a nation among the other nations of the world.  Sargent suggests that Europe must achieve the same goal. (http://www.nobelprize.org/nobel_prizes/economics/laureates/2011/sargent-lecture.html)

While the fiscal crises of the states was going on during this period in the United States there was also a banking crisis going on in the private sector, a lot of it caused by the credit problems faced by the states.

Taking the experience of the United States as an example, one can argue that the only way the European Union is going to “get its arms around the problems” is to form a fiscal union amongst it members that will supplement the monetary union that is already in existence. Many anticipated this next step when the original monetary union was formed. (http://www.ft.com/intl/cms/s/0/50a1f9fe-9466-11e1-8e90-00144feab49a.html#axzz1tp5ngu6K)

However, the fiscal union implies more.  A federal union of countries is going to have to establish its credit standing in the world which means that it will have to be able to issue debt with the “joint and several liability” of the eurozone backing it.  Of course, this implies that the new fiscal union of eurozone countries will conduct it budget operations on a sound basis. 

Furthermore, the eurozone is going to have to move to save European banks.  The European Central Bank cannot solve the whole problem through its “liquidity” efforts.  The countries of the European Union are going to have to provide funds directly to the European banks that need them.  This will not be inexpensive in the short-run.  Hopefully, over the longer run the European Union will get a large portion of the funds back.

European banks are even in worse shape that United States banks.  Bloomberg Markets magazine has just released its list of the strongest banks in the world.  There are only four European banks in the top twenty: two from Sweden, one from the U.K. and one from Switzerland. (http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html)

Whoops!  None of those banks are in countries in the European Union.  Seems like the strongest banks in the world are not in countries that have pursued the policies of credit inflation that have created huge amounts of debt.

The problem is: who is going to lead Europe into a fiscal union?

Angela Merkel, the German Chancellor, has indicated that that is the direction in which she is headed.  Yet, it is not altogether clear that the German people will accept a fiscal union because so much of the load of the new union will be placed on Germany.  Furthermore, you have the move to new governments within the European Union that “anti-austerity” and “anti-German.”

Still, Germans have benefitted more than any country in Europe from the monetary union and from its reunification and from integration with other European countries.  Germany stands to continue to benefit from “more Europe” rather than less. 

And, this is true of the rest of Europe.  It is not an easy path to a new European future, a united Europe, but it will, in the end, produce the greatest amount of wealth and prosperity for the continent as a whole. 

This is a massive undertaking.  A movement in this direction will not resolve all of Europe’s growth problems, its unemployment problems, or, its real estate problems in the near term.  To stay separate, however, in my mind, is almost unthinkable.  We might get a taste of this soon in Greece if a new government comes to power that cannot follow up on the conditions of the recent bailout.  If the new government is unable to deliver, the European Union may ask for it to withdraw.  My sense is that this would be pretty bad.

In terms of the United States bond market, I believe that it will not take the full consolidation of the European fiscal union to reverse the flow of funds coming into US financial markets.  What is needed, however, is some credible leadership to arise in Europe that can achieve some credible gains in movement toward the union.  Given the elections coming up this weekend and in the near term, it is hard to see such leadership ascending.  So, it may be awhile before yield relationships return to more normal levels.        

Treasury Bond Yields Will Continue to Rise

Treasury bond yields are on the rise and will continue to do so over the next year. 

In my opinion, the Federal Reserve System has been given more credit than it is due concerning how low long-term Treasury securities had fallen in the past year or so.

The research I have seen during my professional career has shown that the Federal Reserve, from time-to-time, has attempted to influence the yield on long-term Treasury issues but has never been very successful, either in terms of the its ability to lower long-term yields by much or in terms of keeping them lower for an extended period of time.

This is not true, however, of short-term yields. 

I continue to believe this.

The yield on the 10-year Treasury security has been extremely low for several months now.  Around the end of July 2011, the yield on the 10-year was about 3.00 percent.  It dropped precipitously after that time, falling around 2.10 percent by August 18 and then falling below 2.00 percent the second week of September.

Since then, this yield has fluctuated between approximately 1.80 percent and 2.10 percent until last week (except for a three day bump up right at the end of October).

The most interesting move during this time period, however, has been the move into negative territory of the 10-year TIPS bond.  At the end of July 2011 the 10-year TIPS was trading around a 0.50 percent yield (which was already low historically).  On August 10 the yield had become negative, trading around a -0.155 percent yield.  That is, we had a negative real rate of interest. 

For a good portion of the time since then the yield on the 10-year TIPS has been negative.  Yesterday, this issue closed at -0.056 percent yield.

The reading on this behavior?  The movement into Treasury securities this summer was a “flight to quality” and was not a result of the actions of the Federal Reserve System. 

The Federal Reserve cannot force interest rates…long-term or short-term…below a zero interest rate.  The Fed has been very successful in keeping its target rate of interest, the Federal Funds rate near zero, but admits it cannot force this rate below zero. 

Why would investors invest in something that had a below-zero interest rate on it?  The basic reason is that these investors wanted to invest in Treasury securities…regardless of the yield.  This represented a “flight to quality” and the movement of funds affected the yields on all long-term Treasury securities.

One should note that with all the liquidity available to the financial markets, the spread between US Treasury issues and Aaa Corporate bonds rose during this time.  You do not find this type of behavior taking place except in times when there is a flight to quality.

One should also note that there was also a “flight” to German sovereign debt at this time as the yield on the 10-year German government issue fell, although not by as much as did the yield on the US Treasury issues.

The movement in Treasury yields last week was a movement back into riskier assets.  This is confirmed in a New York Times release this morning concerning the actions of hedge funds. (See “Hedge Funds Ditch Treasuries in Droves: Report”, http://www.nytimes.com/reuters/2012/03/19/business/19reuters-hedgefunds-treasuries.html?src=busln&nl=business&emc=dlbka32_20120320)

“A good deal of the recent flight from U.S. Treasuries has been driven by hedge fund selling…

Last week was the biggest weekly decline for U.S. Treasury prices since last summer. The big sell-off in government debt pushed yields to their highest levels in more than four months.

It was a sign investors see less need to put money in Treasuries for safekeeping now fears of a messy Greek debt default are fading and the U.S. jobs picture looks brighter.”

This, to me, makes much more sense than does the argument that this movement is the beginning of the bear market in bonds. (See “Bond Bear Market is Growling but Yet to Roar,” http://professional.wsj.com/article/SB10001424052702303812904577291770173587542.html?mod=ITP_moneyandinvesting_6&mg=reno-secaucus-wsj)

Also, as the yield on 10-year Treasury securities rose last week the yield on 10-year German bonds rose as well.

Long-term yields will begin to rise at some time in the future but I don’t believe that we have reached that stage of the cycle at this time.  The bond market still needs to re-position itself to risk-based assets and reduce its need for a “safe haven.”  This will continue, I believe, for the short-term. 

I think that the yield on the 10-year Treasury needs to return to above 3.00 percent and the yield on the 10-year TIPS bond needs to get back up into the 0.50 percent to 1.00 percent range.  This will restore some of the relative yield spreads to levels that are more consistent with current economic conditions. 

These yields will begin to rise along with economic growth as the economy picks up steam.  However, I don’t see that there will be much “steam” in the next three or four quarters. (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad) 

Furthermore, the Federal Reserve will continue to err on the side of ease until the economic recovery does appear to accelerate.  Although Fed ease will not hold down long-term interest rates once they begin to climb on any experienced economic pickup, the Fed wants to avoid disruptive bank failures or other surprises that might occur on the path to recovery.

Of course, we could always have another situation in which a further “flight to quality” would cause long-term Treasury yields to drop.  Greece is not out-of-the-woods yet, and there is still Ireland, Portugal, Spain, and Italy to deal with.