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What's Behind Falling US Interest Rates?

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Federal Reserve policy and signals from the ECB have each played a part in the declining US yield curve.

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After being range-bound between 2.6% and 2.8% for most of 2014, the yield on the 10-year US Treasury broke out of the range last week and, for a brief time, was several basis points below 2.5%. This has confounded most macroeconomists, as a strengthening economy with rising inflation expectations and rising interest rates typically go hand in hand.
 
There are a couple of reasons that the yield curve has displayed this unique behavior:
  • Fed policy: There's a growing perception that the Yellen Fed will err on the side of easing, and, as a result, the time horizon before the first rise in interest rates has been stretched. But of greater importance is the speculation that the $100 billion dumping of US Treasury securities in March (Russia is the usual suspect) apparently ended up on the balance sheet of the central bank of Belgium. Since that bank can't print money, the speculation is that it was financed by the Fed via some backroom operation. Thus, the extra $100 billion of liquidity (on top of the regular $45-$55 billion of QE3) has been in play for several weeks.
  • ECB policy: The ECB (European Central Bank) has signaled that it intends to introduce a significant easing package for the EU (European Union) at its June meeting. As a result, European rates have fallen rapidly. The 10-year yields for the paper of Italy and Spain, which were 5% last July, now sit below 3%. Amazingly, France (whose economy has been stagnant for years) now sports a 10-year yield that's 70 basis points lower than its US counterpart. The 10-year bund yield (Germany), which has historically run lower than 10-year Treasuries, now sits at less than 1.3% and is a record 120-basis-point-spread compared to the US 10-year Treasury.
Given the deluge of liquidity and the relative attractiveness of US Treasury paper, especially when compared to the failing economies in Europe, it isn't any wonder that the US yield curve has fallen. But be forewarned -- these are unusual conditions:
  • The $100 billion is probably a one-off situation; such liquidity is unlikely to reoccur, and tapering apparently will continue.
  • The US is now experiencing inflation in its business sector (falling unemployment, unfilled jobs due to skills mismatch, rising Producer Price Index (PPI) and Consumer Price Index (CPI)). This can't be ignored for too long.
  • Markets appear to have priced the ECB's June easing to perfection. Any disappointment (e.g., lack of money printing) in its new policy is likely to result in rate backup in Europe, and US Treasuries may well follow.
Dr. Robert Barone is a Managing Partner/Portfolio Manager of Universal Value Advisors.
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