Last updated August 2014

The level of U.S. Treasury yields is dependent on a number of factors, including many that most investors already know about: inflation, economic growth, U.S. Federal Reserve policy, and investors’ appetite for risk. But there’s another, less appreciated factor: the level of yields in the overseas bond markets.

As outlined here, Treasuries don’t operate in a vacuum – they’re just one of many potential options for large, global investors.

U.S. Treasury yields aren’t just evaluated based on their own merits, but how they stack up against other bond markets around the world.

This matters right now for the simple reason that bond yields in the smaller European markets are so low that any increase in U.S. Treasury yields could cause Treasuries – which are seen as being the gold standard of safe investments – to yield substantially more than the bonds of either Spain or Italy on a nominal basis.

That’s right – Spain and Italy, the poster children for the European debt crisis as recently as two years ago. Along with Portugal, Ireland, and Greece – which round out the group of countries that were dubbed “PIIGS” – the Spanish and Italian bond markets were punished for the countries' slow economic growth, excessive debt, high unemployment, and unwillingness to engage in the kind of structural economic reforms that would bring about a true recovery.

Why Have Investors Returned to These Markets?

Today, it’s a somewhat different story – but not because these countries have enacted meaningful reforms.

Instead, the key reason behind the improved market performance is that Spain and Italy are backstopped by the European Central Bank (ECB).

Not only did ECB head Mario Draghi famously pledge to do “whatever it takes” to keep the Eurozone intact in the summer of 2012, but the central bank has since enacted aggressive interest rate cuts and is leaving open the option of initiating a quantitative easing policy (QE). If this occurred, the ECB would be providing the same type of bond-market support that the U.S. Federal Reserve did when it enacted its various rounds of QE – a policy that it is now in the process of winding up (or “tapering”).

The result of the ECB’s forceful approach is that investors have stopped worrying as much about the creditworthiness of Spain and Italy, and instead plunged into their bond markets to pick up the added yield over other global developed markets. Keep in mind, prices and yields move in opposite directions.

An important outcome of the rally in these markets is that yields have fallen so low that they are on par with those of U.S. Treasuries in nominal (pre-inflation) terms. On June 10, 2014, for instance, the 10-year U.S. Treasury paid investors a yield of 2.64%, while Spain and Italy’s 10-year bonds yielded 2.58% and 2.71%, respectively. The updated yields of each country, along with one-year charts, are available from Bloomberg here and here.

Real Yields vs. Nominal Yields

It's important to keep in mind that these are only nominal yields, not real yields. In other words, they don't take the impact of inflation into account. Currently, inflation in Spain and Italy is lower than it is in the United States, which means real yields are higher. On that front, these two countries still have a yield advantage. But even by this measure, yields have fallen so much in the past year that there is limited room for them to decline much further.

The reason why the gap in real yields can only fall so far is that Spain and Italy are much less creditworthy borrowers than the United States. In other words, the lower yields in these countries mean that investors are being paid less to take on the associated risks.

What this Means for the U.S. Market

This is why the yields in these markets matter for the United States. Say, for instance, that U.S. Treasury yields increase and the move isn't matched by a similar rise in Spain and Italy. In this scenario, the U.S. becomes a more attractive destination for global investors on a relative basis. Why invest in riskier countries when U.S. Treasuries offer competitive returns? The favorable risk-and-return equation in the United States would draw in buyers, which in turn would limit the extent to which yields could rise. Falling yields in Europe already have been a factor in the strong performance of the U.S. bond market through the first half of 2014, and it's an important consideration for the bond market outlook for the rest of this year and beyond.

Could this situation be resolved with rising yields in Spain and Italy? Absolutely – incoming news and economic data or a shift in investors’ risk appetites could cause yields in the smaller European markets to increase, which would provide the latitude for Treasury yields to rise in kind without upsetting the market's risk-and-return dynamics.

The Bottom Line

While it can be challenging comparing markets, the level of yields in Spain and Italy could become an increasingly important factor for the U.S. market in the months ahead.