Buyers Dream of Draghi as Fed-ECB Divide Bolsters Treasuries

As the Federal Reserve moves to end its debt purchases, U.S. bond-market bulls are discovering a new ally: European Central Bank President Mario Draghi.

For the first time since 2007, Treasuries offer higher yields than government debt in Europe. That’s largely due to Draghi, who pushed the region’s borrowing costs to record lows after announcing an unprecedented set of stimulus measures last month including negative interest rates to prevent deflation.

With Fed Chair Janet Yellen trying to extricate the central bank from more than five years of its own extraordinary monetary policies to support the world’s largest economy, the relative advantage may help attract more overseas investors to Treasuries and prolong their biggest advance in four years. At 2.48 percent, 10-year notes yield more than twice as much as German bunds, the biggest premium since 1999.

“It certainly does give the Fed some cover to pursue its agenda,” Tim Palmer, the Minneapolis-based head of global bonds at Nuveen Asset Management, which oversees $120 billion, said in a July 24 telephone interview. “It’s likely to be less disruptive to the extent that other countries are engaging in policies that add some liquidity.”

While forecasters foresaw higher yields at the start of the year as the U.S. economy gained momentum, investors poured into Treasuries as lackluster job growth and turmoil from Russia to the Middle East fueled demand for haven assets.

Fed Skeptics

U.S. government debt gained 3.4 percent this year, the biggest year-to-date return since 2010, data compiled by Bank of America Corp. show. The MSCI World Index of equities in developed nations returned about 6.8 percent, while the Bloomberg Commodity Index of 22 raw materials added 2.7 percent.

Now, as the Fed shifts from buying bonds to debating how soon to raise interest rates, sustaining demand from foreigners who own almost half the $12.1 trillion of outstanding Treasuries has never been more important. Since 2008, the Fed has inundated the U.S. economy with more than $3 trillion of cheap cash with debt purchases aimed at suppressing borrowing costs and restoring demand crippled by the financial crisis.

A growing chorus of investors including Apollo Global Management LLC and hedge-fund manager Stan Druckenmiller are already warning the Fed’s easy money has created asset bubbles and unnecessary risks to the economy.

And as Yellen tries to determine how best to tighten monetary policy without upending the economy beset by slack in the labor market, Dallas Fed President Richard Fisher said in a July 16 speech in Los Angeles that the central bank is at risk of “overstaying our welcome by staying too loose, too long.”

ECB Impact

In Europe, Draghi is pressing ahead with more stimulus as the ECB tries to combat the specter of deflation. On June 5, it cut the deposit rate to minus 0.1 percent, becoming the first major central bank to take one of its main rates negative.

The ECB also announced the central bank will start working on a quantitative-easing-style plan to purchase asset-backed debt and introduce a program to encourage banks to lend that may reach 1 trillion euros ($1.3 trillion).

While Draghi has struggled to weaken the common currency, the measures helped propel the biggest year-to-date returns for euro-area government debt since 1995, data compiled by Bank of America show. Bond yields are now so low the policy differences of the ECB and the Fed have given Treasuries an advantage.

Treasuries from two-year notes to 30-year bonds now yield an average of 1.54 percent, or 0.32 percentage point more than euro-area bonds. That’s the most since 2007. As recently as last year, U.S. debt yielded a percentage point less.

Opposite Directions

“The market has diverged,” Amitabh Arora, New York-based head of interest-rate strategy at Citigroup Inc., said by telephone on July 25. “It has priced an easier ECB.”

Axel Botte, Paris-based strategist at Natixis Asset Management, which oversees $405 billion, says Treasuries may not be worth the risk. U.S. yields will climb as speculation starts to build over when the Fed will need to start raising rates -- at a time when the ECB is boosting stimulus, he said.

Forecasters anticipate the U.S. economy expanding 3 percent in 2015, double the pace in the euro area, data compiled by Bloomberg show. U.S. consumer prices have increased at least 2 percent for three months, the longest stretch since the start of 2012. Inflation in the euro area may rise just 0.7 percent this year, the least since 2009, the data show.

“Our take is that policy will be tighter” than the Fed itself anticipates, he said by telephone on July 23. The gap between U.S. and euro yields “reflects the fact that the market is getting closer to the time where the Fed is likely to hike.”

Reality Check

There’s now a 60 percent likelihood the Fed will start lifting rates by July 2015, futures contracts show.

The tendency to over-estimate the strength of the U.S. economy as well as the Fed’s ability to spur demand will favor bulls in the Treasury market, said Robin Marshall, director of fixed income at Smith & Williamson Investment Management.

In the first quarter, the economy shrank 2.9 percent in the biggest drop-off since 2009 as the pace of new home sales declined and personal consumption fell to a five-year low. At the start of the year, economists surveyed by Bloomberg projected growth of 2.5 percent. At the same time, Wall Street prognosticators have pared their year-end yield forecasts for 10-year notes to 3.03 percent from 3.44 percent in January.

“The recovery in the U.S. is muted and disappointing,” Marshall said in a July 25 telephone interview from London. “Forecasts remain a triumph of hope over experience.”

‘Not Interested’

Yields on 10-year Treasuries provide 1.34 percentage points more in compensation than comparable German bunds, which fell to a record 1.15 percent on a closing basis last week.

In France, 10-year yields plummeted by more than a percentage point this year to an all-time low of 1.53 percent.

Even yields in countries such as Spain and Italy, whose sovereign debt crises pushed the 18-nation currency union to the brink of collapse just two years ago, have fallen so far that they offer little more than U.S. government bonds.

“I’m not interested” in German or French debt, Yoshiyuki Suzuki, Tokyo-based head of fixed income at Fukoku Mutual Life Insurance Co., which manages $59.2 billion, said by telephone on July 17. “The yield shrank too much.”

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