Calling Out the Europe-Wags-US Bond Story

Many, if not most point to the stunning decline in European bond yields as the primary factor driving US bonds over the past year. And it is true, at least anecdotally, that European interest in US bonds has picked up—especially over the last few months, as the strength in the dollar caught everyone’s eye. (After all, an annual 150bps of pickup can be wiped out in a one bad currency day, so you must have a positive view of the dollar.)

Some, with darker take, suggest the decline in absolute yields is a harbinger of bad things to come, that it’s only a matter of time before some version of the deflation and contraction much of Europe is experiencing will arrive on our shores. The precipitous decline in the price of oil since June has only reinforced this negative sentiment.

But the old and grizzled know all too well that price action does not fundamentals make, at least not always. Sometimes it’s about positioning and technicals. Sometimes it’s simple. Sometimes the bond market is not the smartest guy in the room.

Roll tape.

Here are the charts of the German 10yr bund, and the US 10yr note, respectively.

You can see that the yields in both the German bund and the US note have fallen a lot over the past year, even though the decline in the bund yield has been more dramatic and it’s absolute level much lower. In the US note there was a spike in the wake of the 2013 taper tantrum that has been largely retraced.

This is the story that most have in mind when they assert that Europe and/or a looming US growth stumble is driving bonds.

Now let’s have a look at the 2 year maturities, starting with the German schatze:

And here’s the 2 year Treasury:

Now it gets interesting.

If the US were tracking European yields for fundamental reasons, foreshadowing a drop in US demand, why would the yield on the US 2yr be trending higher, while falling and actually turning negative in Germany? (Pls excuse the scale compression on the schatze.)

And, if Europeans were interested in playing the US dollar, particularly if they thought the US cycle was improving (as the anecdote goes), shouldn’t they want to do so at the shorter end of the US curve, since duration risk in an improving economy is a big one?

In short, you can’t have the 10yr yields declining in the face of a rising 2yr yield unless you think the Fed is about to choke out an economic cycle that has barely begun. Moreover, of course, even if this were your view, you couldn’t then argue the Fed is behind the curve and its polices are too lax.

So, while you can get me to believe the European yields are some part of the story, I can’t in the face of these charts see it as a driver. What then, you might ask, could be behind the decline in US long term yields and the rise in US short term yields?

For me, it’s easy. It is the Fed. The Fed bought little in the way of short-term bonds, and what they did buy they swapped out into long-term bonds via Operation Twist. On the other hand, the Fed’s cumulative holdings of long-term bonds has become very, very large. And, if you put them together with holdings of other price insensitive UST holders, and you realize that some 70-75% (~7T of ~9T) of UST notes and bonds are held by entities that don’t care about every tick the way we do. In short, it’s about scarcity. After all, wasn’t creating a scarcity stock effect exactly how the LSAP was supposed to affect rates?