FII Federated Investors Inc

A wave of money fleeing low or negative interest rates overseas is helping to push down long-term Treasury yields, hobbling a popular market gauge of U.S. economic health.

The "yield curve" measuring the premium investors pay to hold 10-year U.S. government bonds instead of two-year notes on Tuesday declined to 0.94 percentage point, the lowest since December 2007. A year ago, the gap was 1.65 points.

The curve now is said to be flattening, a condition that bears scrutiny because it could lead to an "inverted" yield curve, in which short-term rates exceed long-term ones. The U.S. yield curve inverted in June 2007, shortly before the financial crisis, and in December 2000, ahead of the 2001 downturn.

Yet some traders and portfolio managers caution that the yield curve's predictive value may have fallen victim to the age of easy money, in which global financial flows dwarf the economic trends that market indicators have long been taken to illuminate.

While many U.S. investors doubt the 10-year Treasury is a bargain at its recent yield of 1.75%, investors in Europe, Japan and elsewhere have been large buyers, thanks to the even lower yields available in their home countries. The pool of negative-yield bonds hit $9 trillion this month.

The U.S. yield curve is "distorted because of negative interest rates abroad," said Torsten Slok, chief international economist at Deutsche Bank Securities.

The failure of U.S. yields to increase in recent months even as the early year recession scare ebbed has struck many investors as a sign of foreign capital's impact.

The 10-year yield has ticked lower this month, even as U.S. retail sales and consumer-sentiment data showed strength and the Federal Reserve Bank of Atlanta's GDPNow forecasting service predicted that second-quarter U.S. economic growth would hit 2.5%. Stronger data is typically associated with higher bond yields, because faster economic growth tends to push up inflation.

Craig Brothers, a portfolio manager at Bel Air Investment Advisors, still keeps measures of the yield curve prominently displayed on his Bloomberg terminal. But he looks at it less as an indicator of the economy than as a measure of where investors are putting money.

"The bond market had better predictive powers in the past than it does now," said Mr. Brothers, who manages $3 billion of mostly municipal bonds in Los Angeles.

Other factors play a role, too. The yield curve tends to flatten early in a Federal Reserve tightening cycle, as short-term yields rise in response to prospective rate increases while long-term yields rise more slowly alongside the gathering pace of economic activity.

About half of the flattening over the past year is because of an increase in the two-year rate, reflecting expectations for Fed rate increases this year. The two-year Treasury traded recently at 0.82%, up from 0.55% a year earlier.

Momentum also plays a role. Bond trading increasingly is driven by hedge funds and principal trading firms using superfast computers. One popular strategy is known as trend following, which can lead to a cycle in which bond purchases drive down yields, begetting further purchases that further drive down yields and so on.

Traders say that while this process can push yields down further than economic considerations would seem to demand, the resulting gap is vulnerable to sudden reversals.

"The flattening yield-curve trade is crowded," said Stanley Sun, interest rates strategist at Nomura Securities International in New York.

Another underrated factor: diminished supply of Treasurys as improving U.S. economic health reduced government-funding needs. In April 2016, net issuance of Treasury notes and bonds was negative for the first time since 2008, according to Mr. Slok at Deutsche Bank Securities.

History underlines how difficult it can be to get a handle on the swirling dynamics of this market.

A decade ago, the U.S. was running larger and larger current-account deficits and many government bonds were being purchased by China, which at the time was using U.S. Treasury purchases to help hold down the value of its currency, the yuan, and make its exports more competitive on global markets.

This arrangement fueled fears that the U.S. would be vulnerable to a financing crisis if China began selling its holdings, an argument that bearish bond investors contended would vindicate Treasury short sales.

Those concerns came to naught in the financial meltdown of 2008, which instead ignited a massive rally in safe bond prices.

Eight years later, China is selling its Treasurys, but few expect yields to spike imminently, reflecting in part the deflationary concerns driving the economic slowdown in the world's most-populous nation. Meanwhile private investors have stepped into the breach.

Foreign central banks net sold $302 billion U.S. Treasury notes and bonds over the past 12 months through March this year, according to Deutsche Bank Securities. Foreign private investors net bought $317 billion.

Don Ellenberger, a fixed income portfolio manager at Federated Investors, says long-term bond yields will likely remain low as the world struggles to adjust to soft growth, even without a U.S. recession.

"My thought is that we are going to continue to see the curve flatten, but it is going to be a slow grind over a longer period of time," he said.

Write to Min Zeng at min.zeng@wsj.com and Ben Eisen at ben.eisen@wsj.com

(END) Dow Jones Newswires

May 17, 2016 15:45 ET (19:45 GMT)

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