Flood of Foreign Cash Flattens Yield Curve

Why a popular market gauge of U.S. economic health has become more ambiguous

By Min Zeng and Ben Eisen
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A wave of money fleeing low or negative interest rates overseas is helping to push down long-term Treasury yields, hobbling a popular market gauge of U.S. economic health.

The “yield curve,” measuring the premium investors receive for the risk of holding 10-year U.S. government debt, rather than two-year notes, on Tuesday declined to 0.94 percentage point, the lowest since December 2007. A year ago, the gap was 1.65 points.

The curve now is said to be flattening, a condition that bears scrutiny because it could lead to a situation in which short-term rates exceed long-term ones. That happened in the U.S. in June 2007, shortly before the financial crisis, and in December 2000, ahead of the 2001 downturn.

Yet some traders and portfolio managers caution that the yield curve’s predictive value may have fallen victim to the age of easy money, in which the flow of cash around the world dwarfs the economic trends that market indicators have long been taken to illuminate.

While many U.S. investors doubt the 10-year Treasury is a bargain at its recent yield of 1.75%, investors in Europe, Japan and elsewhere have been large buyers because yields available in their home countries are even lower. The pool of negative-yield bonds hit $9 trillion this month.

The U.S. yield curve is "distorted because of negative interest rates abroad,’’ said Torsten Slok, chief international economist at Deutsche Bank Securities.

The failure of U.S. yields to increase in recent months, even as the recession scare early in the year ebbed, has struck many investors as a sign of foreign capital’s impact.

The 10-year yield has ticked lower this month, although U.S. retail sales and consumer-sentiment data showed strength and the Federal Reserve Bank of Atlanta’s GDPNow forecasting service predicted that second-quarter U.S. economic growth would hit 2.5%.

Stronger data is typically associated with higher bond yields because faster economic growth tends to push up inflation.

Craig Brothers, a portfolio manager at Bel Air Investment Advisors, still keeps measures of the yield curve prominently displayed on his Bloomberg terminal. But he looks at it less as an indicator of the economy than as a measure of where investors are putting money.

While many U.S. investors doubt the 10-year Treasury is a bargain at its recent yield of 1.75%, investors in Europe, Japan and elsewhere have been large buyers because yields available in their home countries are even lower. The pool of negative-yield bonds hit $9 trillion this month.

The U.S. yield curve is "distorted because of negative interest rates abroad,’’ said Torsten Slok, chief international economist at Deutsche Bank Securities.

The failure of U.S. yields to increase in recent months, even as the recession scare early in the year ebbed, has struck many investors as a sign of foreign capital’s impact.

The 10-year yield has ticked lower this month, although U.S. retail sales and consumer-sentiment data showed strength and the Federal Reserve Bank of Atlanta’s GDPNow forecasting service predicted that second-quarter U.S. economic growth would hit 2.5%.

Stronger data is typically associated with higher bond yields because faster economic growth tends to push up inflation.

Craig Brothers, a portfolio manager at Bel Air Investment Advisors, still keeps measures of the yield curve prominently displayed on his Bloomberg terminal. But he looks at it less as an indicator of the economy than as a measure of where investors are putting money.

Traders say that while this process can push yields down further than economic considerations would seem to demand, the resulting gap is vulnerable to sudden reversals.

"The flattening yield-curve trade is crowded,’’ said Stanley Sun, interest rates strategist at Nomura Securities International in New York.

Another underrated factor: diminished supply of Treasurys as improving U.S. economic health reduces government-funding needs. In April 2016, net issuance of Treasury notes and bonds was negative for the first time since 2008, according to Mr. Slok at Deutsche Bank Securities.

History underlines how difficult it can be to get a handle on the swirling dynamics of this market.

A decade ago, the U.S. was running larger and larger current-account deficits and many government bonds were being purchased by China, which at the time was using U.S. Treasury purchases to help hold down the value of its currency, the yuan, and make its exports more competitive on global markets.

This arrangement fueled fears that the U.S. would be vulnerable to a financing crisis if China began selling its holdings, an argument that bearish bond investors contended would vindicate bets against Treasury debt.

Those concerns came to naught in the financial meltdown of 2008, which instead ignited a powerful rally in prices of safe bonds.

Eight years later, China is selling its Treasurys, but few expect yields to spike imminently, reflecting in part the deflationary concerns driving the economic slowdown in the world’s most-populous nation. Meanwhile private investors have stepped into the breach.

On a net basis, foreign central banks sold $302 billion U.S. Treasury notes and bonds over the 12 months through March this year, according to Deutsche Bank Securities. Foreign private investors bought a net $317 billion.

Don Ellenberger, a fixed-income portfolio manager at Federated Investors, says long-term bond yields will likely remain low as the world struggles to adjust to soft growth, even without a U.S. recession.

“My thought is that we are going to continue to see the curve flatten, but it is going to be a slow grind over a longer period of time,” he said.

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