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The front page of the New York Times stated what seems like the obvious on Sunday, April 11, 2010: "Interest rates have nowhere to go but up." At the time the 10-year treasury yielded a heady 4%. Since then, interest rates in most of the developed world have been on the decline, with a few notable exceptions (Greece, Russia, Venezuela). The axiom that interest rates have a floor of zero has been tested, and in Europe the axiom has failed. Banks in Spain, Portugal and Italy lately have been in the unthinkable position of paying interest to borrowers with adjustable rate mortgages1.
If recent tremors in the European bond market continue, these halcyon days for mortgage holders may be near an end. The 10-year German bund, whose yield had recently been a hair's breadth above the zero line, rose suddenly to near 0.8%, causing major losses at marquee hedge funds who had bet on a continued decline in rates and the value of the euro2. US treasury yields followed suit, but at a smaller scale, rising from about 1.9% to 2.2%.
It's too soon to say this is the beginning of the end though. The European Central Bank is only now starting its massive quantitative easing program, which will pump €1 trillion into the European financial system between now and next fall. That's a lot of firepower to keep rates low, and as long as rates stay low in Europe, intermediate and long rates are likely to remain well-anchored here, even if the Fed does start to raise.
But perhaps not all US rates will stay low. It's only a nine hour flight from Frankfurt to Chicago O'Hare airport, whose home city just had its credit rating cut to junk by Moody's in the wake of a successful lawsuit fighting pension reform in Illinois. The State of Illinois and city of Chicago yields jumped on the news of the verdict, even before Moody's got around to changing its credit rating.
This action underscores yet again how intractable the problems of some municipal issuers are, and should serve as a warning to other states with massive unfunded pension liabilities, such as New Jersey. It should also be a reminder to investors that as punishing as the persistent low yield environment has been for savers, high yields nearly always come with heightened risks. There's nothing wrong with taking risks, of course, but the combination of low yields and narrow credit spreads doesn't look like a winning combination just now.
1Kowsmann, Patricia and Jeannette Neumann, "Tumbling Interest Rates in Europe Leave Some Banks Owing Money on Loans to Borrowers." The Wall Street Journal, April 15, 2015. http://www.wsj.com/articles/as-interest-benchmarks-go-negative-banks-may-have-to-pay-borrowers-1428939338. Accessed May 14, 2015.
2Chung, Juliet. "Market U-Turn Rams Hedge Funds." The Wall Street Journal, May 5, 2015. http://www.wsj.com/articles/market-u-turn-rams-hedge-funds-1430870382. Accessed May 14, 2015.Print