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Have we seen the top in bond yields?

Treasury yields fell dramatically during 2014 and the beginning of 2015, even in the face of some encouraging economic data. Since mid-2014, there were three primary factors contributing to the continued drop in yields:

  • The dramatic decline in energy and other commodity prices, which threatened more widespread disinflationary pressures in the economy at large.
  • The rapid rise in the value of the dollar, which was spurring demand for lower-cost imports. The increase in low-cost imports was also expected to cause some disinflationary pressures.
  • Relative value. The difference in yield between U.S. Treasurys and German bunds (also called the yield spread) could only get so wide before astute investors would come in and take advantage of the spread by executing an arbitrage trade.

US 10-year yield (green) vs. German 10-year yield (blue)

Source: FactSet

As we survey the landscape today, each of these factors has stabilized or reversed.

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First, the yield on the 10-year German bund has increased sharply to 0.68 percent from a low of about 0.08 percent in mid-April. At the same time, the yield spread between the 10-year Treasury and the 10-year bund has narrowed to about 159 basis points from the high of about 190 basis points on March 10. It seems clear that the dramatic widening in spread between the two bonds (over the previous couple of years) had triggered some arbitrage investing. Indeed, we recently heard some very public comments from a couple of major hedge-fund investors arguing that the German bund (and other European sovereign debt, for that matter) had become dramatically overvalued (meaning yields were too low). This assessment was due, at least in part, to the wide yield spread that had developed.

Second, the price of oil has bounced quite dramatically from its lows. In fact, the price of a barrel is up about 28 percent (for WTI crude) from the low in mid-March. The stabilization in energy prices has helped convince bond investors that perpetually lower oil prices will not lead to more widespread deflationary pressures.

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And finally, the dollar has dropped about 6 percent against a basket of major currencies since mid-March. Here again, the firming in the dollar has convinced some bond investors that a continued surge in low-cost imports (resulting from a stronger dollar) may not cause more widespread deflationary pressures.

Oil (green) vs. the dollar index (blue)

Source: FactSet

Is this increase in Treasury yields sustainable? I continue to believe that one of the major factors containing interest-rate increases in the U.S. will be the still historically wide spread to the German bund. Notwithstanding the continuation of quantitative easing in Europe, we think fixed-income investors would rather earn 2.25 percent in a currency still widely expected to appreciate versus 0.68 percent in a depreciating currency. Moreover, we tend to believe the slow-growth environment in the U.S. is here to stay for a while, limiting the upside for interest rates.

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Stay tuned, but the 2.35 percent level we hit this week on the 10-year Treasury may prove to be the top over the near term.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.