Higher US Treasury yields might provoke another European sovereign crisis

In a market controlled by central banks' overly accommodative monetary policies, it has been refreshing to see government bond yields rising quickly. Expected inflation pressures, a fast vaccination program, and the Federal Reserve's impasse is suggesting that such rise in yields will continue to be supported, if not accelerated in the coming months. This poses a dilemma to other central banks worldwide, which have recently seen their respective government bonds selling off together with Treasuries.

Higher US Treasury yields are dragging up yields in Europe, Australia and the Emerging markets. While such a trend can be tolerated in the United States amid a better economic outlook, other economies are concerned that they may provoke a tightening of financial conditions as their economic expectations remain gloomy.

The case is particularly worrying for Europe as capital markets have been clearly more correlated than the economy, posing a serious threat to the recovery.

In this analysis, we find that higher US Treasury yields inevitably imply higher Bund yields. However, central banks' monetary policies can significantly reduce the correlation between the two. When looking at the periphery, things look extremely worrying.  Once hedged against the EUR, US Treasuries are offering a much higher yield than the most vulnerable countries in the European Union. It means that soon we might see a rotation from the periphery to securities across the Atlantic, which might cause another event such as the European sovereign crisis.

If such a scenario were to materialize, the ECB and the European Union might be forced to take extreme measures to resolve such a crisis that would see the bloc going one step further into its monetary unification, levelling out the cost of funding in the Euro area once and for all.

A positive correlation between German Bunds and US Treasuries is detrimental amid a clear divergence in the economies

The correlation between the two securities is justified because higher yields in the US might persuade investors to allocate more money there versus Europe, provoking a correction in the old continent’s sovereigns.

It’s interesting to note that since the global financial crisis of 2008, the spread between 10-year Treasury and Bund yields has been widening despite yields in both continents have been falling. The trend implies that German yields have been plunging more rapidly than US Treasury yields. Noticeably, during the Covid-19 pandemic in 2020, the spread between the two has been tightening quickly. Why? Bund yields have little space for falling further. Hence the tightening of the spread is attributable mainly to the fall in US Treasury yields. This is important because it tells us that while Bund yields have limited potential to fall, they have an unlimited potential to rise.

It is important to notice that in the past 20 years, the correlation between US Treasuries and the Bund had fallen near zero only twice: in 2016, when Trump won the US elections and in 2019. In both cases, the movement in US Treasuries has been bigger than in Bunds, for the simple fact that European monetary policies have anchored the Bund to ultra-low level.

Summing-up, as yields continue to rise in the United States, we can expect Bund yields to follow suit unless the European Central Banks intervenes to reduce or even break the correlation between the two.