The Bond Market's Great Elastic Band Act
Yields on 10-year U.S. government bonds have risen 40 basis points since September, about as much as German 10-year Bunds yield in total. The more than 200 basis point difference between the two debt market bellwethers is increasingly difficult to justify.
It's the lack of yield in Europe that looks out of whack. Just like the U.S., growth is picking up here. Inflation and wage expansion doesn't look to be far behind, which is usually toxic for bonds.
Supply's also increasing in most European bond markets in the first quarter, particularly in longer maturities. Just as the European Central Bank's QE buying program is being halved to a monthly pace of 30 billion euros ($35.8 billion).
But European bond yields have seemed immune to the upward track of their U.S. counterparts. Bunds have been anchored in a narrow yield band throughout 2017 of between 15 and 60 basis points. It's tough to imagine that the range won't shift higher in 2018.
Euro zone growth and inflation forecasts were raised again at the ECB's last meeting. With the oil price climbing back above $60 per barrel, external inflation pressure is rising too.
Mario Draghi often cites market expectations of inflation in five year's time as his favored guide. That measure has risen steadily over the second half of 2017, as the chart below shows, but not bund yields. Keeping a lid on European yields is going to become trickier as pressures mount from both within and without.
The real upward pressure is coming from the shorter part of the U.S. interest rate curve. Goldman Sachs Group Inc. and JPMorgan Chase & Co. analysts expect the Fed to raise rates as much as four times in 2018. That makes sense given that the Atlanta Fed predicts at least 3 percent of GDP growth next year. The passing of the tax reform bill will only underpin this.
Some $1.3 trillion of U.S. Treasury issuance is forecast in 2018 by JPMorgan, the most since 2010, just as the Fed is planning to start tapering QE. With the spread between two and 10-year U.S. yields the narrowest for a decade at barely 50 basis points, it could easily widen. And that would bring implications for all bond markets.
Three-year U.S. Treasuries are already "banging at the door" of two percent yields, the danger level cited by bond market guru Jeff Gundlach, chief investment officer of DoubleLine Capital LP. That's more than 250 basis points higher than German three-year yields, which are at minus 53 basis points.
Five things could drive U.S. long-end yields upward next year: Higher Fed rates, more supply, QE tapering, stronger growth and inflation. It will require Herculean will from the ECB to resist the inexorable pressure from the last four of those factors in Europe as well. And that will only bring forward the inevitable day when the ECB has to contemplate that first one too -- hiking rates as the economy recovers. Now that is logical.
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