According to Deutsche Bank (DB) there’s a huge premium baked into U.S. treasury bonds right now thanks to fears about a European debt crisis. That’s why U.S. treasury yields are extremely low, with the 10-year yield near 2.93%.
One reason they suspect this premium is that the U.S. 10-year bond has been substantially correlated to deterioration of the euro, which stood out as one of the market’s main reactions to the Eurozone crisis. This is shown by the top chart shown below, and is one factor in DB’s calculations.
For this and other reasons, Deutsche believes the Euro crisis premium could be from 60 – 100 basis points, which equals 0.6 – 1.0%. This means that if fear of a European crisis abates, U.S. treasuries yields could shoot back up to near 4%, as shown in the bottom chart show below.
Uncertainty about the situation in Europe has generated a substantial flow of “safe haven” money into US Treasuries… 10-year Treasuries are 60bps to 100bps lower than what is predicted by short rates, the business cycle, the fiscal stance, and inflation expectations. As the worries about Europe start fading among global investors – including later this week when the stress tests are released – we would expect the Greece premium in 10-year Treasuries to start shrinking.
Thus if this premium dissipates and U.S. government bond yields soar back to 4%, U.S. government bond prices will nose-dive. (Bond prices move in the opposite direction of yields) That’s how the recent Treasury rally could completely unwind. So keep an eye out for clues about Europe’s financial health tomorrow, when they release bank stress test results.