One major implication of the rate rise in the U.S. has been changing interest rate differentials. While emerging markets are seeing their rates rise in panicky fashion (accompanied by major currency declines), much of the developed world has actually seen less of an interest rate rise than the U.S. What surprises me the most is the rate differentials between the U.S. and Europe.
Europe has shown some signs of recovery. Today’s flash PMI was better than expected as well, sending European equity markets up 1% this morning. But this is still a deeply flawed currency union with seriously undercapitalized banks.
In that sense, if you asked me whether I would rather put my money in U.S. 10 year Treasury bonds at 2.92%, or French 10 year bonds at 2.48%, I’d choose the U.S. in a heartbeat (mainly because of my greater trust of return of capital, rather than any slight difference in return on capital). In fact, the spread between the 10 year interest rate swap in the U.S. and France is near 6 year lows:
I am totally amazed that French 10 year bond yields are below the U.S., and most of the world, for that matter. But no need to pick on France. After this summer’s rate rise, the U.S. 10 year yield is only 1.4% below that of Italy, which is currently at 4.37%, and only 1.55% below that of Spain, which is at 4.51%!
The 10 year yield differential between Italy and the U.S.:
The 10 year yield differential between Spain and the U.S.:
So you only get paid an extra 1.5% to hold Italian or Spanish bonds over the next TEN years? Good luck with that. If you think 7.5% unemployment is bad, try 15-25% unemployment and an unending political carousel to boot.
One explanation for this is that European banks have loaded up on sovereign bonds because of their better capital treatment among European regulators. But that has seriously distorted the market. Moreover, France, Spain, and Italy do not even control their own currency. I point all of this out because while European stocks look cheap vs. the rest of the world, European bonds look terribly mispriced relative to other countries.
Even if all goes well, the incremental risk vs. return is not a worthwhile tradeoff. In my view, this is one more reason that the Euro is much more likely to fall in the coming months, despite its stubborn strength. Just as Indian, Indonesian, or Turkish yields were far too low 6 months ago, European yields look far too low today.