Haven appeal of US Treasuries wanes

Will Europe’s gain be America’s pain? As fears of a sovereign debt and banking crisis in the eurozone have eased, so too has the safe-haven appeal of America’s Treasury market. Benign bank stress test results, surprisingly good eurozone economic data last week, successful debt auctions on the continent’s periphery and a 9 per cent appreciation in the euro since its early June nadir have pierced the gloom.

But America’s Treasury market seems not to have received the memo. Two-year yields hit a historic low on Friday and 10-year yields remain a full percentage point below their April level. Low yields have helped Washington resist, for now, the pressure for fiscal austerity while treating American consumers to the cheapest mortgages in history.

Is the party nearly over? Strategists at Deutsche Bank say that, absent panic flows from Europe, 10-year note yields should be 60 to 100 basis points higher. Not only would financing costs surge but investors who have poured money into bond funds would suffer stinging losses. But such a rout seems unlikely. Futures traders’ lingo for “10s under twos”, the spread between the two maturities, remains a relatively rich 240 basis points. The all-time record hit earlier this year was 292 bp.

In a normal economic expansion, signs of a slowdown or recession in coming quarters have been accompanied by a low or negative spread. Yield curve inversion flagged recessions in August 1978, January 1989 and February 2000, plus false alarms in 1998 and 2005. But these are not normal times. The US Federal Reserve remains reluctant to tighten ultra-loose monetary policy, anchoring the short-end of the curve. Only fears of inflation have kept long rates from moving even lower. After three straight months of falling prices, inflation expectations have room to go even lower, as do yields. Eurozone crisis or not, look out below.

James Mackintosh is away