Head of Fixed Income Strategy
Summary: In this analysis, we find that there is a positive correlation between US Treasuries and the Bund, but that central banks' monetary policies can significantly reduce it. We believe that if US yields continue to rise, there a risk that another European sovereign crisis will materialize as a rotation from the periphery to safer US Treasuries becomes more and more compelling. Indeed, once hedged against the EUR, US Treasuries are currently offering a much higher yield than the most vulnerable EU countries.
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.
The periphery is at risk amid rising US Treasury yields
The synchronic relationship between US Treasuries and the Bund is key when looking at all those assets that price over the Bund, especially sovereigns of the periphery because they are a key risk factor for the entire European economic recovery.
Since the European sovereign crisis, we have witnessed a fast spread compression of all European sovereigns versus the Bund. Tighter spreads managed to hide, but not change, investors’ risk perception of the periphery until the Covid-19 pandemic. Indeed, as coronavirus cases quickly spread in Italy and lockdown measures were imposed, investors quickly dumped peripheral debt. Today risk premiums in the periphery are even lower than pre-Covid-19. Nevertheless, it doesn't mean that they are safer investments than before.
The absence of aggressive fiscal policies and new dovish central bank goals makes the periphery even more vulnerable at the moment. If the selloff in US Treasuries continues, we will most likely see investors dumping sovereigns in the periphery to invest across the Atlantic. After all, the periphery is currently offering a return close to zero for 10-year government bonds. Once hedged against the EUR, 10-year yields offer around 0.8% YTW, which is the same yield that 10-year Greek government bonds offer. As yields in the US continue to rise, the differential between the two will continue to grow making it hard to justify holding Greek debt when you get paid the same or even more in the US safe heavens.
This point will be a huge headache for the ECB, which knows perfectly well that a rise in cost of capital in the Euro area will be detrimental to all the policies enforced until now.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
