In recent days, I've noticed a growing sense of concern among investors that this year's surprising strength in the U.S. bond market can't last, particularly when it comes to the longer maturities. If they are right, it won't be for the reasons typically cited.
Investors worry that U.S. Treasury yields could rise — and prices decline — as a result of a durable and pronounced pickup in economic growth or a meaningful increase in inflation. I suspect these fears are overblown. There's a third possibility, though, that could have the same effect: a shift in the relationship among global interest rates.
For much of this year, U.S. Treasury yields have been reacting to, rather than driving, developments in interest-rate markets. True, the Federal Reserve's reluctance to abandon quickly its accommodative monetary-policy stance, particularly in the context of the first-quarter decline in gross domestic product, has helped keep yields low. But Europe has played a more important role. The Fed's moves to end quantitative easing, and the steady improvement in the job market, would certainly have had more impact on U.S. rates were it not for three external forces that have cumulatively led to a sharp fall in European yields.
First, Europe’s economic recovery, weak as it is, keeps losing momentum as governments delay action on structural reforms and fiscal policy.
Second, the European Central Bank is responding with a looser monetary policy characterized by negative deposit rates and a more aggressive bond-buying program.
Third, the crisis in Ukraine has had a further contractionary impact on the European economy.
The resulting decline in European bond yields has made U.S. Treasurys look attractive even at their own historically low yields. The 10-year German bund, for example, now yields about 1.5 percentage point less than the comparable U.S. Treasury note.
Now, though, currency markets are on the move. Expectations of slower growth and lower interest rates in Europe have pushed the euro's exchange rate down to less than $1.30, from nearly $1.40 in May, taking some of the downward pressure off U.S. yields. Hence, there is a growing probability that longer-maturity U.S. yields will rise, both on their own — specifically in the 10-year note — and in relation to Europe.
So if you're worried about the bond market, it shouldn’t be because of an acceleration in U.S. growth or inflation. The real threat is the increasing and multifaceted divergence between Europe and the U.S.
© Copyright 2021 Bloomberg L.P. All Rights Reserved.