In our March 25 Market Commentary, we discussed the reasons why Treasury yields kept falling in the face of some incrementally more positive economic data. We said that there were three factors driving US Treasury yields lower. The first was the dramatic decline in energy and other commodity prices, which threatened more widespread disinflationary pressures on the economy at large. The second was the rapid rise in the value of the dollar, which was spurring demand for lower-cost imports. The increase in low-cost imports was also expected to cause some disinflationary pressures. And the final and perhaps most important factor was relative value. We said that the difference in yield between US Treasuries and German bunds (also called the yield spread) could only get so wide before astute investors would come in and take advantage of the spread by executing an arbitrage trade.
Now, just six weeks later, each of these factors has stabilized or reversed. First, the yield on the 10-year German bund has increased sharply to 0.68% from a low of about 0.08% in mid-April. At the same time, the yield spread between the 10-year Treasury and the 10-year bund has narrowed to about 159 basis points from the high of about 190 basis points on March 10. It seems clear that the dramatic widening in spread between the two bonds (over the previous couple of years) had triggered some arbitrage investing. Indeed, we recently heard some very public comments from a couple of major hedge-fund investors arguing that the German bund (and other European sovereign debt, for that matter) had become dramatically overvalued (meaning yields were too low). This assessment was due, at least in part, to the wide yield spread that had developed.
Second, the price of oil has bounced quite dramatically from its lows. In fact, the price of a barrel is up about 28% (for WTI crude) from the low in mid-March. The stabilization in energy prices has helped convince bond investors that perpetually lower oil prices will not lead to more widespread deflationary pressures. And finally, the dollar has dropped about 6% against a basket of major currencies since mid-March. Here again, the firming in the dollar has convinced some bond investors that a continued surge in low-cost imports (resulting from a stronger dollar) may not cause more widespread deflationary pressures.
Is this increase in Treasury yields sustainable? Of course, it’s anyone’s guess. However, we continue to believe that one of the major factors containing interest rate increases in the US will be the still historically wide spread to the German bund. Notwithstanding the continuation of QE in Europe, we think fixed-income investors would rather earn 2.27% in a currency still widely expected to appreciate versus 0.68% in a depreciating currency. Moreover, we tend to believe the slow-growth environment in the US is here to stay for a while, limiting the upside for interest rates. Stay tuned, but the 2.35% level we hit yesterday morning on the 10-year Treasury may prove to be the top over the near term.