Wah! Market wants bond blankyMay 30, 2012: 3:54 PM ET
Investors have had enough of this whole Europe mess.
They continue to dump stocks -- the S&P 500 (SPX) is now down 7.5% since hitting a 52-week high in April . They are getting rid of oil, gold and other risky commodities. They are unloading stocks and bonds tied to troubled European nations like Spain and Italy. (If you are looking for a bad omen, the Spanish 10-year yield was near a demonic 6.66% Wednesday.) And investors are rushing into the supposed safety of the best of the developed world's debt.
The yield on the 10-year U.S. Treasury note hit a record low of 1.615% Wednesday afternoon. 10-year rates for German, Swiss, British and Japanese debt have also tumbled. The yield on the German 10-year bund fell to 1.276% Wednesday -- also a new all-time low.
In case you flunked Fixed Income 101, it is time for the requisite reminder that bond yields fall when prices are rising. So investors are clearly making a mad dash to the few places of the world left that they view as safe and secure. Call this developed world debt the market's blanky, if you will.
But how much lower can bond yields, particularly in the U.S. and Germany, go? The 10-years of Japan and Switzerland ... which unsurprisingly also have two of the world's strongest currencies in the yen and franc ... are both below 1%. Can rates really get that low in a little country that Mitt Romney's tech team likes to call Amercia? (Does that rhyme with panacea or inertia?)
Brian Battle, director of trading at Performance Capital Trust Partners in Chicago, said that the 10-year Treasury could probably get to 1.5% pretty quickly if there is more bad news about Europe. All the market would need to justify an even bigger rush into Treasuries is a "screaming headline" he said.
But Battle does not think that the 10-year will fall much lower than that.
"It's possible that the U.S. 10-year gets to 1% but it's not probable. Things would have to get significantly worse to knock yields down that much further. There would probably be a resolution in Europe before then," he said. Battle added that it's important to remember that investors aren't buying bonds (and bunds) because they like the economic prospects of the U.S. and Germany.
"People are buying Treasuries because they are denominated in dollars. It's not that people are craving a 1.65% yield for the next 10-years," he said. "It's a similar story in Germany. You may not be fleeing currency risk because Germany is part of the euro, but investors are more comfortable seeking a haven in German assets."
David Joy, chief market strategist with Ameriprise Financial in Minneapolis, agreed. He said that this safe haven buying environment could go on "indefinitely." Yields in the U.S. and Germany could continue to decline, he argues, until there is real conviction that the problems in southern Europe are truly fixed. That's not likely to happen anytime soon.
In fact, Joy thinks that the worries about Europe are creating more fears of a global slowdown and deflation as opposed to inflation. Here's your requisite dose of Fixed Income 102. Bond yields are often extremely low in times of deflation. Look at Japan since, oh, about the past fifteen years for an example.
"There is a growing sense that the market is more worried about deflation than inflation. So even at record lows, high quality sovereign bonds are the only real place to be in that environment," Joy said. "There is this fear factor. The default position is to just step aside."
Joy is right about that. CNNMoney's Fear & Greed Index has been firmly entrenched in "extreme fear" mode for the past few weeks.
Still, what happens if investors suddenly decide that the U.S. and Germany aren't as safe? Would a plunge off the fiscal cliff in the U.S. later this year send bond yields higher? Or what about a Greek exit from the eurozone leading to true contagion in Europe that creates massive losses at big U.S. and German banks? Wouldn't that push rates higher for bonds and bunds?>
Perhaps. But a spike in safe haven yields seems far less likely than a continuation of the status quo. After all, the Federal Reserve would probably want to avoid a situation like 1994, when rates quickly surged and caused economic pain.
In other words, the Fed can be counted on (for better or for worse) to prop things up with a third round of quantitative easing if the U.S. economy takes a turn for the worse. QE3 would be a signal to investors that every time so-called bond vigilantes were selling, the Fed would be there as a buyer of last resort.
Investors can't ignore other foreign governments either. China and Japan continue to be big holders of U.S. Treasury debt. Until that changes, don't expect yields to move significantly higher.
Still, rates may not remain this low forever. Gene Needles, CEO of American Beacon Advisors, an investment firm in Fort Worth, Texas, said he is surprised that rates have gotten this low this quickly.
Although Needles believes investors will remain nervous about Europe for the foreseeable future, he thinks people need to realize that they are actually losing money slowly on Treasuries when you consider that the rate of inflation, even as low as it is right now, is higher than the yield on the 10-year. Needles said investors should look for steady income elsewhere, citing quality corporate bonds or dividend-paying stocks as examples.
"This may not be a bubble in the short run. But when inflation eventually picks up, this will end badly. Not many investors have experienced a bear market in bonds. They are just as ugly as bear markets for stocks," he said. "Bonds are a parking place and the meter is ticking."