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Watch out as those bond yields drift upwards

Louisa Bojesen
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Something very interesting is happening in the bond market these days, and, yes, it has to do with the enormous amount of bonds that are being issued by governments. In one word, it can be described as distortion. For a very long time, even with the knowledge that budget deficits were ballooning from government overspending, yields on the US 10 year Treasury note have been nicely below four per cent. But record high debt sales can not go on forever with yields staying so low – and indeed they hit 4.0095 per cent yesterday, according to BGCantor Market Data. Yields are on their way up as government debt, previously seen as “safe”, gets questioned. A potential aid package for Greece was hammered out recently, but the trouble may not stop there, as other countries could find themselves in a similar pickle of not being able to repay their debt. This includes the UK and now it seems investors are questioning the US and its debt pile too.

This is where interest rate swaps enter the picture. They are a derivative where one party exchanges a stream of interest payments for another party’s stream of cash flows. Or, stated differently, an exchange on interest rate exposures, between two parties, from floating to fixed rates or vice versa.

Treasury yields usually trade below swap rates as Treasury funding is seen as less risky. But this is changing. For the first time since swaps were introduced, the 10-year interest rate swap has been trading below the US 10-year note. This has been the case in the UK gilt market since January, and the inversion is becoming even more pronounced as we head toward an uncertain general election. According to Bryn Jones, a fixed income fund manager from Rathbone, this reflects investors’ perception that US (and UK) credit risk is higher than it has been in the past.

Laurent Fransolet, a managing director at Barclays Capital, points out that fundamentals are also playing a role. It is the possibility of more aggressive fiscal consolidation in Europe which has made European bonds outperform US and UK bonds. Conversely, it is the better prospects for US growth and inflation that have contributed to pushing US yields higher.

Louisa Bojesen is a presenter on CNBC’s Squawk Box Europe each weekday morning -- http://europe.cnbc.com