11 Sep 2018
By Richard Turnill
We see the yield spread between US and German bonds modestly widening on US economic outperformance and policy divergence.
The gap between the 10-year yields of US and German government bonds has steadied at elevated levels after a long period of widening. We see room for modest widening of this spread, a barometer of the relative long-term growth outlook and interest rate expectations in the two economies. Why? We see better long-term growth prospects and a faster pace of monetary policy normalisation in the US.
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The relative long-term economic outlooks for the US and eurozone are major drivers of the yield spread between US and German government debt. Stronger data in the US has lifted confidence in the country’s long-run prospects relative to Europe. We use our BlackRock GPS to illustrate this relation: The Treasury/bund yield spread (the teal line) has tracked the economic growth expectation differentials (the dark blue line) between the US and eurozone in recent years. It has widened since late 2017 as US growth expectations outpaced those of Europe, driven by anticipation of tax cuts and fiscal spending – eventually hitting the widest levels in almost three decades earlier this year. European growth data have steadied recently after downgrades to consensus estimates. Yet our GPS points to greater potential for upside growth surprises in the US than the eurozone – even as macro uncertainty rises.
Inflation and policy expectations are also key drivers of the Treasury/bund yield spread. US inflation is likely to hover around the Federal Reserve’s 2% target in the near term, while eurozone inflation is expected to stay far short of the target set by the European Central Bank (ECB), our BlackRock Inflation GPS suggests. The slippage in eurozone inflation expectations since 2013 has helped suppress and cap European bond yields. Mirroring the gap between growth and inflation expectations, the two central banks have been on diverging policy paths. The Fed has been raising rates since late 2015 and is expected to stay on its gradual normalisation path through 2019. The ECB, by contrast, is only slowly winding down its crisis-era asset purchase program, with no rate increase expected until at least mid-2019. We see this contributing to a modest further widening of US-eurozone interest rate differentials.
The supply and demand dynamics of these securities influence the spread too. The US Treasury is ramping up debt issuance to fund a rising budget deficit – the result of tax cuts and spending increases. Issuance in the first seven months of this year already surpassed that of the entire 2017. This comes as Germany is reducing debt issuance. Ten-year bund supply is expected to fall nearly 20% this year. The size of the free float has shrunk to just over 10% of outstanding German bunds supply, from over 40% when the ECB started its quantitative easing program in 2015. The result: a scarcity of bunds that has put a cap on their yields.
Bottom line: We expect policy normalisation to lead to modestly higher long-term rates in the US and eurozone, and the Treasury/bund spread to widen moderately as the Fed leads the normalisation effort. The widening Treasury/bund spread reflects economic fundamentals that underpin our preference for US over European equities – and could lend some support to the US dollar versus the euro. Rising short-term yields price in a quarterly pace of US rate hikes – and make the front end of the US Treasury curve attractive for US dollar-funded investors, we believe. Risks include a pause in the Fed’s rate rises due to tremors elsewhere.
Global equities fell, led by technology stocks. The value style outperformed in both developed markets and EM. The Indonesian rupiah fell to a 20-year low versus the US dollar, and the South African rand fell more than 4% this week. Italian government bond yields fell and stocks rallied as budget concerns eased.
Date: Event
Sept. 10: China Producer Price Index (PPI) and Consumer Price Index (CPI)
Sept. 11: Germany ZEW Indicator of Economic Sentiment
Sept. 13: Turkey’s central bank monetary policy decision; ECB meeting; Japan machinery orders; U.S. CPI; German CPI
Sept. 14: China urban investment, industrial output, retail sales; US retail sales; University of Michigan Surveys of Consumers
Solid growth in US retail sales likely extended into August, driven by robust back-to-school sales, the tailwind from tax cuts and reflecting the positive growth backdrop shown by our BlackRock Growth GPS. The Fed’s “Beige Book” business survey may garner some attention this week, after the last edition in July highlighted escalating trade conflicts as a top concern among businesses. See our BlackRock geopolitical risk dashboard for more on global trade tensions and their potential impact on markets.
Richard Turnill is Global Chief Investment Strategist for BlackRock.
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