Beware of twist in tale of low bond yields

Investors love a simple story, and little in bond markets is simpler than the explanation of why US yields are so low: buyers fleeing low or negative yields in Europe are dragging them down.

The 10-year US Treasury bond yields just 1.91 per cent, in spite of a consensus forecast that the economy will expand 3 per cent this year.

True, after last week's weak jobs figures futures markets have pushed back expectations for the first US interest rate rise, now putting the chance of a rise in June at only 7 per cent. Even so, the transatlantic divide in monetary policy is extreme, with the European Central Bank engaged in quantitative easing as the US Federal Reserve prepares to tighten, if perhaps a little later than had been thought.

The divide is most obvious in the benchmark 10-year yields: the gap between Treasuries and Germany's Bunds (which yield 0.18 per cent) is the biggest since shortly after the Berlin Wall fell. In the eurozone, only Greece has a higher 10-year yield than the US. Shockingly, Spain and Portugal's 2-year yields both turned negative on Tuesday. Flight to the US is obvious and in some cases public.

It may not be the whole story, though. The long bond yield can be compared to a series of expected short-term yields over the period, using futures prices. The remainder is the "term premium", a reward for the risk of locking up money for 10 years.

It is this term premium which should be driven down by buying from European yield-hunters. Sure enough, it has plummeted (see chart). Yet, the fall began at the start of last year, long before ECB QE was considered possible. Aside from a brief acceleration ahead of the QE announcement, the pace of decline has been pretty steady ever since, suggesting something more than a spillover from Europe.

This is the opposite of what might be expected as investors debate the date of the first US rate rise. More uncertainty about the path of rates ought to lead to extra reward in the form of a higher term premium, but the "premium" is now negative for the first time since 2012.

The danger for US bond buyers is a sell-off as the term premium snaps back. With the European story explaining only part of the fall since 2013, watch out for a plot twist.

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