I have been fascinated by the deluge of commentary linking Quantitative Easing in Europe with declining interest rates in other parts of the world, particularly the United States. The basic argument is that investors are buying US Treasuries to replace European bonds because they have a higher yield. This argument is obviously flawed: the higher yield in US dollars brings with it currency risk and additional volatility, so they are not substitutes. In theory, due to the absence of arbitrage, an investment in US Treasuries, when fully hedged back to Euro, should deliver the same return as a German Bund.
That said, as the Bloomberg grab shows, there does seem to be some relation between QE in Europe and the declining yields in the US. It is still difficult to believe that intelligent investors treat a 2% yield for a 10 year Treasury as a substitute for a 0.2% yield for a 10 year Bund. So what rational explanation can there be for ‘QE spillover’ effects?
For monetary actions to have real economic effects, they must influence either technology, fiscal arrangements or investors attitude to risk. It is hard to argue that the ECB can influence US production technology by it’s actions. Equally, it is unlikely that the US Congress would alter its path for taxes and expenditures in response to Mario Draghi’s shopping spree in Frankfurt. Could it be that US bond investors feel slightly more comfortable watching the ECB aggressively buying bonds and assigning a lower risk premium to US bond investments than previously? A cyclical reduction in investor risk aversion may well be what we are witnessing in the US bond markets.
A lower risk premium implies a flatter yield curve in the US. The yield curve there has been unusually steep for many years as the markets have been sceptical of the Fed’s commitment to lower interest rates. Observing the ECB’s aggressive action may well have convinced the sceptics in the US to step out into longer maturities. This would seem the only rational explanation.