Negative real yield era in Europe set to end
The gap between yields on US and German 10-year government bonds has reached its widest level in almost three decades. Is this trend at an inflection point or will we see further decoupling between the US and other developed markets?
Markets expect the Federal Reserve to deliver at least two additional interest rate hikes in 2018. Beyond this, US interest rate futures indicate markets are priced for one interest rate rise in 2019 and none the following year. Reflecting these expectations, the treasury market has flattened considerably, with the short end selling off aggressively and the long end anchored by expectations the Fed’s terminal rate will be lower in this cycle.
However, we believe it may be too soon for markets to discount the end of the tightening cycle and the risk still remains for rates to go higher. While pressure is likely to remain on treasuries, particularly in the medium part of the curve, given the magnitude of the moves experienced already, it will be important to trade duration positioning tactically as it is unlikely rates will rise in a straight line.
Macro evolution will be key
The story so far this year has been of the US economy outperforming peers, as momentum in several developed countries slowed. The UK stands out in this regard, after a string of weak data releases led to the markets pricing out rate hikes. This provided a boost for local bonds.
In the eurozone, the slow pickup in inflation and the deceleration in economic growth have been supportive for government bonds versus the US. However, it is important to note the eurozone economy is still growing above potential and it is possible the European Central Bank (ECB) will end its bond-buying programme sooner rather than later – a development markets have yet to fully factor in.
We believe European bonds will have to play catch-up with treasuries at some point. We are not sure how long real yields in Europe can remain in negative territory if domestic growth steadily delivers above 2% for the next two years.
Examine technicals and issuance
Technical factors also need to be considered. The rapid rise of US Libor has been a headwind for treasuries, while international investors have bought more European bonds and have reduced Treasury holdings due to the expensive cost of hedging dollars.
Supply considerations must also be taken into account. During the first quarter, the US Treasury announced net borrowing totalled a record $488bn, over $40bn more than expected. With tax cuts and increased government spending, US deficits are expected to continue widening. To fund this, more treasuries will need to be issued, raising an additional question mark over value.
Investors also need to survey currency markets for signs of whether the decoupling is also influencing foreign exchange. Until recently, the interest rate differential had not led to specific US dollar appreciation. We are sceptical about the recent trend reversal, believing the market has been too focused on short-term data. Therefore, the backdrop of steady growth and a large current account surplus should be supportive for the European currency. The time may be coming for the market to show the euro a bit more love.
Expect end of decoupling in credit
The corporate sector is one market where the decoupling could come to an end. US investment grade corporate bonds have struggled year-to-date, while European counterparts have held up better. However, it is possible this divergence will end soon as the level of the ECB’s Corporate Securities Purchase Programme has dropped significantly in the past four weeks. This follows a frontloading of buying earlier in the year to meet larger-than-expected bond supply.
We believe European investment grade corporate bonds could be vulnerable to a correction, with the ECB potentially stepping away from markets at a time of heavy bond issuance.
Quentin Fitzsimmons is portfolio manager of the T. Rowe Price Dynamic Global Bond fund