What Is Driving U.S. Treasury Yields?

With the economy on the path of recovery and the Federal Reserve pulling back on stimulus, have you been expecting bond yields to start moving upwards? If yes, hold your horses before you juggle your portfolio or take any position in the financial markets based on this assumption. It’s true that U.S. stock markets have achieved record highs recently; however this has not been successful in drawing investors away from safe haven assets like Treasuries, with the result that yields are still at an all-time low.

As of now, benchmark 10-year yields are hovering at levels of about 2.34%, and quite recently they even touched a 14-month low of 2.3%. Moreover, as far as market sentiments go, no one is really expecting the yields to rise anytime soon.

“Why is that?” you might ask. Well, the answer could lay in the fact that contrary to the expectations of most, it isn’t really the Federal Reserve that is driving interest rates right now, but the European Central Bank!

If you take a look at bond yields across Europe, you will find that as a result of persistent Central Bank stimulus programs and sluggish growth, many countries are experiencing historically low yields unseen in at least the last two centuries. Recently, German 10-year debt stood at 1.11%, a level last seen by the country in early 1800s, while Spanish 10 year-debt yielded 2.19%, its lowest in 200 years. Netherlands debt yield was lately at its lowest in 500 years, while French debt stood at levels last seen 250 years ago. Conflicts in the Ukraine and the Middle East, plans for sanctions against Russia, and the weakening of the Euro have also put pressure on European bond yields. All this in turn has depressed Treasury Yields because … if long-term rates are low everywhere, investors would naturally tend to prefer U.S. government bonds over European Government Bonds. Some investors also believe that Treasury gains are linked with movements in Bunds (German Government Bonds).

The persisting wide spreads between U.S. Treasuries and Bunds make it an attractive carry trade for European based traders to sell Bunds and buy Treasuries. A declining Euro also makes this trading strategy all the more appealing, since it leads to positive currency benefits.

Another explanation could be derived from the fact that a short while ago, the 10-year yield curve fell relative to the 2-year yield curve. According to some experts, this “flattening of the yield-curve,” tends to occur when bond investors don’t think economic growth and inflation in the long-term will outpace economic growth in the short-term. Recently Fed Chair, Janet Yellen, also expressed her concerns regarding the underlying weakness in the labor market at the annual Jackson Hole symposium. All this seems to indicate that the Federal Reserve will continue to maintain a dovish policy stand, which will keep Treasury Yields at low levels in the near future at least.

In fact, in the current rally, you could even expect yields to fall to levels of 2%. However, if global political tensions subside, the demand for U.S. bonds could come down and yields could easily go back to levels of 2.6 – 2.7%.