What the Bond Market Knows That You Don’t

by Matt Tucker, iShares

A picture is worth a thousand words:

Equity Performance vs. Bond Yields

Source: Bloomberg (1/13/11-1/16/12)

On the back of improving US economic data, equities have rallied off of autumn lows, and yet US Treasury yields have continued to surf bottom with the 10-year note trading below 2% for the first time on record. Why haven’t interest rates recovered in support of improving data? Do US Treasury investors know something that equity investors don’t?

The answer may lie across the pond in Europe. The European crisis intensified significantly in the fall, causing equity markets (and most risky assets for that matter) to sell off and US Treasury rates to fall, despite the August downgrade.

The chart below shows the on-the-run credit default swap contract for a basket of European sovereign credits, including the peripheral countries. As the chart shows, spreads widened significantly in late summer / early fall and have yet to recede meaningfully, despite grinding progress on the political front and some prominent actions by the European Central Bank to stabilize liquidity.

Source: Bloomberg

While the United States certainly has well publicized fiscal problems, it is, as our colleague Jeff Rosenberg of BlackRock Fundamental Fixed Income states, “the best house in a bad neighborhood.” To this point, Russ Koesterich estimates that the fair level of rates for the US Treasury 10-year yield based upon historical economic relationships is around 2.5-3%. The current yield of ~1.85% essentially reflects a liquidity or “safety” premium that investors are willing to pay in order to have relative safety in the neighborhood (protection money, if you will). Additionally, the Fed continues with Operation Twist, which is intentionally designed to keep a lid on longer term US Treasury rates (in response to concerns that the European overhang could damage the fragile US recovery).

How long will US Treasuries stay at this level, and will they eventually move up to reflect tentatively improving economic conditions in the United States? It all depends upon Europe. If the European situation deteriorates from here, US equities will almost certainly retreat, and US Treasury investors will look justified in having accepted a low yield, since it was low in anticipation of this risk. In that situation, US Treasury yields could move even lower.

If Europe claws its way out of the worst potential outcome and gets to a point of relative stability, the liquidity premium in US Treasuries will likely dissipate and yields may move to more fundamentally justified levels. But for now, it does appear that bond market and equity market investors are making very different bets.