U.S. Bond Premiums At Multi-Year High
Marc Chandler | Nov 25, 2015 11:45AM ET
This Great Graphic was composed on Bloomberg. It shows two time series. The yellow line shows the premium the U.S. pays over Germany for two-year money. The white line shows the premium the US pays over Japan for two-year money.
The premiums have risen sharply since mid-October and today are at new multi-year highs. In the middle of October the U.S. premium over Germany was near 80 bp. Today it was near 136 bp. Although the German 2-year yield has fallen below -40 bp, it is the U.S. side that accounts for most of the movement over the past month. The U.S. two-year yield has risen almost 30 bp over the past month. The German yield fell by almost 10 bp.
German yields are negative out through six years. In fact, yields out to four years are lower than the ECB's deposit rate, which effective excludes them from QE operations. Draghi's dovish comments fueled anticipation of action next week, in effect forcing the ECB to cut the deposit rate further or face greater difficulty securing sufficient German instruments for purchase.
Japan's yield curve is slightly negative through three years. Japan's two-year yield has slipped a couple basis points over the past month to yield minus 3 bp. The U.S. premium over Japan for two-year borrowing dipped below 54 bp in mid October. Today it is near 95 bp.
Some non-yen based investors are finding it lucrative to buy a short-term JGB and swap the yen into dollars to earn more than one can earn from buying a similar dollar maturity outright. U.S. companies have been heavy issuers of euro-denominated bonds and are swapping their proceeds back into dollars, making for cheap funding.
Before the crisis hit, the U.S. two-year premium over Germany was near 175 bp. That's the next major target. In the second half of the 1990s, as the Clinton dollar rally gained momentum, the U.S. premium peaked near 275 bp. In 2006, the U.S. two-year premium over Japan peaked near 430 bp. While this seems to be unreasonable in the foreseeable future, the U.S. premium will likely increase further and a 150 bp spread does not require too much of an imagination.
Conceptually, we can understand that a particular event can be discounted by the market, which is an incredible anticipatory mechanism. However, investment and hedging decisions for next year or 2017 will be influenced by the incentive structure created by the interest rate differentials and slopes of curves. The claim that the market has discounted the divergence of monetary policy does not ring true to us. The growing premium the U.S. offers creates an ongoing incentive to be long dollars. Moreover, we learned from Dornbusch that overshoot in the currency markets is part of the cycle.
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