The European Rising Tide Failed to Lift This U.S. Boat
By Rom Badilla, CFA
August 20, 2012
We spend a lot of time on the macroeconomic picture as bond pros since it sets the dinner table for the main meal of investment strategy. Growth and inflation, coupled with monetary policy are one of the main factors in determining the direction of interest rates.
When economic data surprises to the upside, the outlook for growth improves. As economic growth begins to accelerate, resources such as materials, factories, and people are being utilized. As more and more resources become used to a point where they become scarce, the price to use them begins to accelerate. Commodity prices ranging from food to metals start to rise while people’s income and wages start to increase as finding qualified workers becomes difficult. When these costs move high enough where they are passed along by producers to final goods and services – items we use on a day to day basis, they become a problem when individuals can no longer afford them.
So when these price pressures amount to rising inflation, bond yields increase. This occurs because bond buyers want higher yields in order to be compensated for the rising prices of items they can buy in the future. As holders of fixed income securities, the value of their bond investments falls as prevailing market yields are higher.
Conversely, when inflation is flat or declining (via disinflation or deflation), yields decrease which in turn lead to an appreciation in bond prices.
Having said this, we look to see how the economy is performing in order to see the direction of interest rates. The next chart shows the Citigroup Economic Surprise Index which attempts to quantify actual economic data against market expectations via Bloomberg’s survey median. Generally a positive reading means that economic numbers are better than what market participants are expecting. As a result a positive surprise may push up bond yields and equity prices since growth is improving. Conversely, a negative number means disappointment which typically results in stocks tanking and an outperforming bond market via a decline in yields.
This is evident when you overlay the yield of the 10-Year U.S. Treasury with the Economic Surprise Index. It is apparent that there is a strong relationship between the two as shown in the next chart.
That is, the correlation between the two variables remained fairly strong over time, except in mid-2011 where the relationship began to fall apart when economic data improved relative to expectations but Treasury yields stayed relatively low. The Citigroup Surprise Index bounced higher from a low of -117.2 in early June to a high of 85.7 in early December of that year.
Given the rationale and historical evidence, you would expect to see that interest rates would increase during that time. However, that was far from the case as yields continued to plummet. The yield on the 10-Year fell almost 100 basis points from 2.99% to 2.03%.
So the question is why the divergence? If we look to another indicator, it is fairly easy to determine why Treasury rates did not increase along with the improving economic data starting in mid-2011.
Interestingly at the onset of the divergence, the Euro dollar relative to the U.S. started to tank as the crisis in Europe began to escalate when peripheral bond yields started to surge. In June 2011 when the Surprise Index hit its cycle trough driven by disappointing economic data, the Euro was trading at 1.4635. At that cycle’s peak in early December, the Euro had fallen to 1.3391, for a decline of almost 9 percent.
In other words, the bond market started to take its cue from other another source of risk and not the usual suspect in U.S. macroeconomic data. As capital fled the Euro region, demand for safe-haven assets such as U.S. Dollars and U.S. Treasuries surged. As a result, Treasury yields didn’t go up but were suppressed given the dire situation in Europe.
With the ECB’s pledge to save the Euro at all costs, it appears that concerns abroad are taking a backseat and the focus is now back to the U.S. macro picture where recent economic data have come in higher relative to expectations. This explains as to why yields have been increasing lately. However, this uptick may be short-lived.
Given that the ECB continues to act alone in supporting the Euro and fiscal imbalances remain without a strong convincing commitment to burden sharing among the developed and the peripheral economies, there is a strong possibility that Treasury yields will begin to take its cue from the Euro again. The question is what is the catalyst for markets to bring the focus back across the Atlantic?
If you look at the calendar when the entire Northern Hemisphere returns back from holiday in September, there are plenty of events on slate that could disappoint. On September 6, another test on Spanish solvency and credit-worthiness is scheduled as the Spanish government will auction more bonds with the hope that their borrowing costs will remain low. In addition, the ECB is scheduled to meet that day. If policy action doesn’t result in some form of Quantitative Easing or “money-printing,” disappointment could deflate risk-seeking market bulls.
In the event that Europe does not flare up again, yields may continue to follow stateside economic data. Keep in mind that the current upward trend in improving economic data may run into another major headwind that is made in the “good ole U.S. of A.” and reeks of political brinkmanship and indecisiveness.
Markets remain short-sighted for the time being with little focus on the impending Fiscal Cliff that follows the November elections. The uncertainty it brings can be prohibitive to consumer spending. Failure to address it could lead to a significant drop in economic activity which in turn may lead to a double dip for the U.S. economy. Interest rates would stay true to its natural path by following U.S. macro data. At that point though, it would be far from ideal since in that scenario, Citigroup’s Surprise Index may begin to disappoint which could push Treasury yields lower.
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