BOND MARKETS REFLECT DIVERGING GROWTH AND POLICY PROSPECTS
The U.S. economy continues to pick up, while Europe is hitting a soft patch, if not decelerating.
They’re at it again. The yields on U.S. and German government bonds, widely considered to be the least risky in the world, continue to confound investors and market analysts.
In a busy week for the global economy and central banks, movements in yields managed to switch directions and drivers, all within 24 hours. In the process, markets signaled to investors the importance of adding the greater divergence of growth performance and policies to the list of factors that will affect some key prices in the months to come.
The latest twists and turns in fixed-income markets began June 13 with the conclusion of the two-day policy meeting of the Federal Reserve. Yields on U.S. Treasuries rose across the curve, with the 10-year reaching a high of around 2.96 percent. This pulled German bonds yields up, with the 10-year trading around 0.48 percent.
That trend was broken on June 14, when the European Central Bank announced the outcome of its policy deliberations. Treasuries yielded center stage to Bunds, which then began to move in the opposite direction, dragging down Treasuries in the process. Suddenly, 10-year Bunds were trading around 0.396 percent and Treasuries around 2.90 percent.
The immediate explanations for these movements contained twists that are likely to have more relevance for markets in the weeks ahead. Let’s start with the Fed, the first of the two drivers.
For the first time in a very long while, the Fed’s decision was slightly more hawkish than I had been expecting. The anticipated 25 basis-points hike in the most-watched policy rate and the openness to another hike as soon as September were accompanied by a change in projections (albeit involving just one of the key “dots”) that raised the Fed’s baseline signal for 2018 to four rate hikes from three.
The next day, the ECB took over from the Fed in exerting systemic market influence. It incorporated in its announcement an unanticipated addendum related to the path of interest rates in 2019. Mario Draghi, the president of the ECB, provided an unexpectedly dovish addition to the bank's plan to reduce its monthly purchases under its quantitative easing program after September and, if the data support it, stop buying bonds entirely at the end of December. At a news conference, Draghi said the soonest the next rate hike could occur would be after the middle of next year.
Taken together, these developments added up to a greater widening of the policy differential between the Fed and ECB than had been expected by markets. This was amplified by data suggesting that U.S. economic growth continues to pick up, while Europe is hitting a soft patch, if not decelerating to a lower path.
The growth and policy differentials could widen further in the months to come, putting fully in play two notions that markets had excessively embraced last year: a synchronized pick-up in global growth and more correlated central bank policies in the new era of quantitative tightening.
Economic developments in the next few months are likely to highlight more and more that U.S. growth is a major outlier in the advanced world. The U.S. is benefiting from policy actions that fuel three simultaneous and interrelated engines: higher consumption, underpinned by a strong labor market; greater business investment, supported by relatively strong balance sheets; and increased government spending, including on account of tax cuts.
In Europe, absent a stronger policy effort, the natural economic/financial healing process that delivered higher growth will prove less effective in sustaining it. And then there's the possibility that tit-for-tat tariff announcements could result in a full-blown trade war. If this were to occur (and it is by no mean certain it will), because the U.S. economy is relatively less open, the growth differential would swing even more in its favor, notwithstanding an overall hit to global growth.
Markets don't yet fully reflect these growth and policy evolutions. As such, households and companies, as well as governments (especially in the more vulnerable emerging economies), should prepare for some combination of further dollar strength, the possibility of even wider U.S.-German yield differentials, and a greater flow of funds to the U.S., both from international sources and as a result of capital repatriation.
Mohamed A. El-Erian, Bloomberg 18 June 2018