- German government bonds relatively resilient to Treasury sell-off…
- …cross market correlations for longer maturities have fallen but still high
- We think US and German yields will both move higher in 2014, but Treasury yields at faster pace
- Meanwhile, French economy not as weak as suggested by the PMI surveys
Bunds resilient to Treasury downturn
Last week’s positive development for government bonds was something of a rarity. Bond yields have drifted up over the last few months. However, the rise in US Treasury yields has been much sharper, with their German counterparts recording a more modest gain. Since their low on 23 October, US 10-Y Treasury yields have risen by around 35bp. This reflects the re-building of expectations of Fed tapering, as well as more convincing signs that the US economic recovery has entered a stronger phase. Over that period, German 10-Y Bund yields have risen by just 5bp. Although the uptrend in US Treasuries and signs of economic recovery in the eurozone have put upward pressure on yields, these have been partly offset by the downtrend in eurozone inflation to very low levels.
Correlations for longer maturities have fallen
A look at correlations between US and German government bonds paints a mixed picture. Correlations (90-day moving average) for 2-Y and 5-Y US yields versus their German counterparts show that these remain relatively high (+0.63 and +0.73, respectively) and even somewhat higher than historical averages (going back to 2000). This is also in line with the very high correlation in money market futures. The correlation between implied rates on 5th and 9th position Eurodollar and Euribor futures remain extremely elevated (around +0.8) suggesting the ECB has, up until now, not been very successful in decoupling expectations of its monetary policy from that of the Fed. In contrast, correlations for 10-Y (see chart) and 30-Y US yields versus Germany show that these have fallen below their historical averages recently, though they remain deep in positive territory.
Cross Atlantic monetary policy divergence
Looking forward, we think that US and eurozone yields will both move higher by the end of this year, but the rise in Treasury yields is likely to be sharper. This reflects a starker divergence in the monetary policies of the Fed and ECB. We expect the Fed to continue to taper its asset purchases and hike rates in 2015. Meanwhile, we think that the likelihood of yet lower inflation makes further policy easing from the ECB a distinct possibility. So the short end could start to show a more diverging picture, which will also be reflected in 10-Y spreads.
France not as weak as suggested by the PMI survey
Last Friday, the Banque de France (BdF) published its business sentiment indicator for December, which declined to 100 from 101 in November. According to the BdF, this would still be consistent with GDP growth of 0.5% qoq in Q4 of 2013, following -0.1% qoq in Q3. This result of the BdF’s indicator is in stark contrast to the results of the earlier published composite PMI, which fell from 48.0 in November to 47.3 in December, well below the boom-bust line of 50 and pointing in the direction of another contraction of GDP in Q4. We have looked at how closely the different surveys have moved in line with GDP growth in the past. It turns out that both in the very long-term (since January 1980), as well as in the very-short term (since January 2010), the Banque de France indicator has the best fit to GDP growth. In the meantime, the PMI index tacked GDP growth rather well between May 1998 (start of the series) and the end of 2009. However, since around the start of 2012 it has been seriously underestimating GDP growth. In fact, it seems the boom-bust level separating growth from contraction no longer is at around 50 but closer to 45. This means that at its current level the composite PMI would be consistent with GDP growth of around 0.2-0.3% qoq in Q4. Indeed, we think that France’s GDP growth bounced back into positive territory in Q4 (we have pencilled in 0.2% qoq).Overall, the French economy is not as weak as suggested by the PMI survey.