Are Bunds poised to outperform US Treasuries?

On Thursday, the European Central Bank (ECB) delivered a well telegraphed 25bp rate hike and updated its projections for growth and inflation. President Christine Lagarde did not give many concrete hints as to where monetary policy rates are moving in the future, but the conclusions were quite clearly that if oil and gas prices do not reverse course, then more hikes are warranted.

Lagarde spoke about the resilience of the economy, and the fact that inflation had seemingly peaked at a lower level but will remain above target for longer than initially expected. Both growth and inflation projections were revised higher, sentencing those who expected a dovish hike to endure a painful 15-20bp sell-off at the front end of the euro curve.

Sadly, the pain did not end with the short end move. Longer maturities were already having a mildly bad day, but the combination of the ECB, higher oil prices driven by the Iran conflict and a poor US market open pushed 10-year and 30-year US Treasury (UST) yields to multi-year highs, with most government bond curves following in tandem. 

The current market narrative is that if oil and gas prices were to fall as a result of some sort of ceasefire and a resumption of transit in the Strait of Hormuz, then we would see a rally in rates across the board – not least because market expectations at the moment are for no resolution in the near term. While we most definitely agree with this, the underlying factors that have caused the move higher in longer term rates do vary across different currencies.

If we look at the euro curve, for example, the sell-off since late June has had more to do with rising inflation expectations than it has in the US. The German seven-year inflation breakeven is at 2.38%, up nearly 70bp since then. The US seven-year breakeven is up about 30bp. Conversely, German real interest rates, as measured by inflation-linked bond yields, have outperformed the US equivalent (see Exhibit 1).
 

With European economies generally having lower potential growth, higher domestic savings, smaller (albeit still large) budget deficits, and a central bank that can show a decent track record when it comes to bringing inflation back to target, our view is that if and when the dust settles over Hormuz, Bunds should experience a more sustainable rally than USTs and eventually outperform as inflation breakevens move lower. This decline in breakevens would be a repeat of what occurred when the initial 60-day ceasefire was agreed in mid-June.

We see little reason for real yields in the US to move dramatically lower, with budget deficits expected to remain at current levels and heavy longer dated issuance to finance the AI trade. Conceptually, real yields are those that bring savings and investment to an equilibrium. The US is already heavily reliant on foreign capital to fund its budget deficit, while the private sector is also raising enormous amounts of money for AI investments. If you've got US dollars to invest, there are several companies and governments competing for your money and in fact savings by US citizens are not enough as it is to fund said investments. In euros, governments are not in need of money to fund deficits to the extent that the US is, there is a lot less AI investment, and domestic savings are significantly higher.

While G7 government bonds have relatively high correlations, taking a medium-term view, we think Bunds are likely to perform better than USTs, which should also be reflected in other euro denominated fixed income asset classes.