The bond market is putting distance between European and U.S. government bonds. Yields on U.S. 10-year Treasury have climbed twice as fast as yields on similar German government bonds since the start of December, according to Bloomberg. The bonds had traded in sync since April 2007.
The cause?
A belief that a faster growing U.S. economy will lead the Federal Reserve to raise interest rates well before the European Central Bank does. The consensus among economists is that the U.S. economy will grow by 2.6% in 2010 while the German economy grows by 1.9%.
You can see one reason for this conclusion if you look at unemployment rates for the two economies.
The U.S. economy lost just 85,000 jobs in December and official U.S. unemployment stayed steady at 10%. In December the official unemployment rate for the 16 euro economies climbed to 10% from 9.8%. The 10% rate is the highest in 11 years.
An increase in interest rates by the Federal Reserve would drive down the price of already-issued bonds until they yield the same as newly issued bonds do. Yields on 10-year U.S. Treasury notes have climbed (which means prices have tumbled) by 0.45 percentage points to 3.83% since December 4. The yield on comparable German bunds rose just 0.2 percentage points to 3.38% in that period.
JPMorgan Chase told Bloomberg that it expects that the yield on U.S. 10-year Treasuries will reach 4.1% by June 30 while the rate on German bunds falls to 3.35%
Since rising yields create loses for bond owners and falling yields generated profits, not surprisingly bond investors have been moving out of U.S. Treasuries and into European bonds such as German bunds. Last quarter U.S. Treasuries lost 1.32%, while German bunds returned 0.13%, according to Bank of America Merrill Lunch.
If the JPMorgan Chase projection of a 4.1% yield by June 30 is correct, Bloomberg calculates that a bond investor who sold Treasuries and bought bunds would earn a profit of about 2.1%.
Jim: I wonder since yields will be inching higher in the near future, if you would opine on the so called “bank loan variable” funds that are paying a premium (higher) rate then most other short term duration bonds.
What does this expected increase in interest rates do to TIPS, and to junk bonds?
1. How does the huge bag of bad paper that the Fed took away and the bad debt in the commercial real estate market affect the bond markets?
2. John Naisbitt (China’s Megatrends), who lives in China at least part of the time and runs an institute at a university there, says about 90% of Fortune 500 companies are conducting business in China. This should mean that whatever happens to their business in this country should be at least partially buffered by the business they conduct in an economy that is growing by least 8%. This should help to make a double dip recession less likely.
Jim,
How does this effect the value of FNMIX fund which you recently mentioned.
Personally, I’m feeling like we are at somewhat of a crossroads. Don’t want to be in bonds and don’t want to be heavily in stocks. So what’s one to do?
Right now I’m sitting pretty heavy on cash. Minimal bond exposure. The very few stocks I’m buying are seemingly solid dividend payers with my most recent being NSTAR (a utility).
Don’t know if I’m heading in the right direction or not but it’s the best I have come up with so far.
Jim,
It would be great if you could elaborate on this article and the like-minded comments by Bill Gross in his January blog: http://tinyurl.com/yefgeuw
* How does the U.S. purchase it’s own debt? Or do I misunderstand Mr. Gross?
* How will a flight to more fiscally conservative bond issuers, e.g., Germany affect asset classes (Gross says we’re in for a bad stock year).
* What is an investor to do? We’re looking at a bad year for bonds *and* a bad year stocks as the carry trade comes to a screeching halt. Guess we start buying German bonds? Utilities?
Jim,
Is that “consensus among economists” about U.S. growth based on the new health care reform law? Since the Congress and Senate haven’t agreed on a final version, I tend to doubt it.
However, a tax increase, which will undoubtedly be part of the bill, could have a significant impact on that 2.6% estimate, even potentially eliminating ANY growth, especially if the Fed raises rates this year (although I am sceptical about that possibility).
Jim, you mentioned late last year that a rise in interest rate would crash the carry trade, whats your take now? You mentioned since then that the yen is replacing the dollar in the carry trade.