Can Treasuries and Bunds Keep in Lockstep?
It has become the conventional wisdom: The bond market often does better than other markets in signaling the outlook for both the U.S. and the global economy. This is particularly true of movements in “safe” government interest rates and in spreads on the more default-sensitive securities.
Recently, this close relationship has shown two noteworthy characteristics:
- Over the past 15 months, the yields largely have been range-bound in the 140-180 basis point area (see charts below), despite major -- and often desynchronized -- developments in the U.S. and German economies, as well as disruptions from China.
- The two bonds have alternated in taking the lead in the relationship: When German bunds led, the yield on U.S. Treasuries tended to be pushed lower. When U.S. Treasuries took the lead, the bund yield tended to move higher.
The foreign exchange markets have played an important role in accommodating and reacting to this pas de deux of Treasury and bunds amid unusual economic developments and the reliance on unconventional monetary policies on both sides of the Atlantic. Specifically, currency moves have helped maintain a relatively range-bound yield spread relationship, even though Europe and the U.S. have pursued different central bank policies and have divergent growth rates. The 2014-15 appreciation of the dollar against the euro, for example, helped mitigate the influences on the markets of the stronger U.S. expansion and the more dovish actions of the European Central Bank.
Relative-value investors have also played a part in maintaining the range-bound relationship: They sold bunds to buy Treasuries when the spread became too tight and did the reverse when the spread approached, or on a few occasions exceeded, the upper end of the range.
Looking ahead, such a range-bound relationship is likely to receive less support from the currency market when it comes to reconciling economic and policy discrepancies. As a result, the national economic and policy forces that influence the spread relationship really do matter. So will the dancing partner who will be taking the lead in the event of growing divergence.
It is likely that the continued gradual healing of the U.S. economy will pull yields in one direction while the likelihood of expanded ECB balance sheet operations will pull in the other. The result is likely to be greater volatility within an expanded trading range. That would be consistent with a global economy contending with multi-speed national economic growth rates, opposing central bank policies in the two most systemically important regions in the world, and incomplete global policy coordination.
The longer-term outlook is much murkier. Close yield convergence could materialize in two ways. The first would be via good outcomes, such as the U.S. helping to pull up Europe while a broader range of policy-making entities join the European Central Bank and deliver a more comprehensive policy response. Or it could be via bad outcomes, such as the contamination of U.S. economic and financial prospects by a mediocre European economic performance and a struggling emerging world.
The uncertainty, though it is significant, has a silver lining: Policy makers today still have opportunities to produce better outcomes tomorrow.
The past five years:
Dec. 2013 to Oct. 2015:
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