The 10-year Treasury Bond Yield

On December 21, 2010, I made the following brash prediction:” my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5-5.0% in the upcoming year, a rise from around 3.3% to 3.5% now“ (http://seekingalpha.com/article/243018-long-term-treasury-yields-in-2011).

I still believe that this is where the yield on the 10-year Treasury security should be. The reason that it is not at this level for two reasons: first, because United States Treasury issues are still attracting a lot of money that is staying away from risk elsewhere in the world; and second, the Federal Reserve System is supplying lots and lots of liquidity to the financial markets (through QE2) in order to keep banks, state and local governments, and the housing market afloat (http://seekingalpha.com/article/246081-the-world-debt-crisis-lingers).

As can be seen from the chart, the yield on 10-year Treasury securities dropped off at the start of the recession which began in December 2007, but then nose-dived as the investor “flight-to-quality” accelerated in 2008. After some stability was re-established in 2009 the yield rebounded into the 3.5% to 4.0% range until 2010 when the sovereign debt crisis took place in Europe.

Note that the Federal Reserve maintained the effective Federal Funds rate within the 15 to 20 basis point range from December 2008 until the present. Excess reserves in the banking system that were less than $2 billion in August 2008, rose to just under $800 billion in December 2008 and averaged around $1,000 billion from October 2009 to the present. Thus, banking and financial markets were sufficiently liquid during this time period.

Right now, the yield on the 10-year Treasury securitiy seems to be dominated by what is going on in Europe. (See the next chart.) We see that this yield was moving in the 3.6% to 4.0% range at the start of 2010. However, as the sovereign debt crisis picked up momentum in the early part of the year, money flowed from European financial markets to United States financial markets.

As the European Union and the European Central Bank seemed to be working out a “bail out” plan for the eurozone nations and banks, confidence seemed to pick up in Euorpe and money once again flowed out of the United States and back into European financial markets.

Perhaps a leading indicator of this money flow could be the value of the United States dollar relative to the Euro. Although the yield on the 10-year Treasury did not begin to decline until April 2010, the United States dollar got stronger relative to the Euro beginning in January 2010. As the European bailout became a reality in the summer, the Euro began to gain strength in June 2010. The yield on the 10-year Treasury started to pick up again in August 2010 but its rise did not really accelerate until October 2010.

Note that as the concern over the sovereign debt problems in Europe rose again toward the end of 2010, the value of the Euro started to weaken again relative to the United States dollar. The rise in the yield on the 10-year Treasury security stalled.

This week, Greece issued bonds on Monday and these securities were relatively well received. Likewise, Portugal had a good reception for its issue of bonds brought to market yesterday. Spain comes to market tomorrow. Along with these successes, the value of the Euro relative to the US dollar rose slightly.

In addition to this, the yield on the 10-year Treasury issue rose Tuesday and was up again this morning.

It appears as if the near-term movement in the yield on the 10-year Treasury issue will depend more on how international investors move their money between European financial markets and the financial market in the United States.

The impact of the Federal Reserve on this? To me, the Fed is primarily interested in the liquidity available to the financial markets and the solvency of the American banking system. It is not going to change its policy stance at the current time. But, its effect on the 10-year yield will be minimal at this time.

Thus, the 10-year Treasury yield is going to bounce around as it has for the last year based upon how successful Europe is in overcoming its debt problems. I still believe that the Treasury yield would rise to the 4.5% to 5.0% this year if the European situation were not having such an impact.