US Yield Curve Set To Continue Underperforming
US Treasury yields seem to have found some sort of base over the last few days, or a short term one at least. The recent sell-off has left many fixed income investors with what has been the worst start to a year in a long time, with 10-year and 30-year USTs having delivered total returns of -4.25% and -11.83% respectively year-to-date.
German Bunds have also had a negative start, though total returns have been (slightly) better at -2% and -8.5% for the 10-year and 30-year respectively. Looking further down the credit spectrum, in high yield the EUR and GBP indices have outperformed their USD equivalents (US HY and hard currency EM). The EUR curve has clearly outperformed the USD curve and has done so with lower volatility. This is something we had expected for 2021, and if anything the confidence level we have in this prediction has increased in the last few weeks given what has happened.
Firstly, the US economy is doing well and on top of that the Biden administration is likely to pass a sizeable fiscal stimulus plan. In Europe we are likely to see some additional fiscal action in certain countries, but of nowhere near the same magnitude. This will likely lead to growth being more robust in the US than in Europe, which bodes worse for US Treasuries than it does for Bunds. Secondly, the rollout of vaccines in the US is also going well with some states having vaccinated close to 20% of their population already. In the EU the picture is quite the opposite as most countries are lagging behind the US and the rest of the world. This should be another boost to growth in the US vs. Europe, which again should put more pressure on US Treasuries than Bunds.
Finally, central bank responses to the government bond sell-off have been quite different. Numerous Fed officials have reiterated that this is what is expected at this stage of a recovery; economic prospects are improving, growth forecasts get revised upwards, inflation expectations increase. In summary things are going quite well, and in this scenario a rise in government bond yields does not necessarily bring about a tightening of financial conditions. We have no doubt the Fed is monitoring closely the speed of the adjustment in yields and whether or not financial conditions change as a result. We also have little doubt it would act if the latter were the case. But at the moment the Fed doesn’t seem to think the adjustment has been too quick or that inflation expectations are out of line. In other words, they believe the economy can take higher rates and that the recovery should continue unabated.
The ECB on the other hand is in a different position. Given a weaker economic recovery, a slower rollout of vaccines and lower levels of fiscal stimulus in 2021 in the Eurozone, a large adjustment in Bund yields might actually result in a tightening of financial conditions. This is reflected in comments by ECB officials, the latest of which was Francois Villeroy who said the ECB “can and must react against” unwarranted rises in bond yields. Isabel Schnabel also warned last week that a rise in real long-term rates in the early stages of the recovery, even if reflecting improved growth prospects, “may withdraw vital policy support too early and too abruptly given the still fragile state of the economy. Policy will then have to step up its level of support”.
In this context it is important to remember that the Pandemic Emergency Purchase Program (PEPP) has capacity to buy €1.85 trillion worth of assets. So far the ECB has used €866.7 billion of this capacity. Data will vary from week to week but so far the average has been around €18 billion per week since the programme started. Last week, for example, there were quite a few redemptions in the ECB portfolio so the net amount they bought was lower than the average, but this is just noise. In our view the ECB has the tools and the willingness to prevent an undesired rise in euro government bond yields. The Fed most definitely has the tools but the economic reality makes it a lot less willing to intervene further at this stage.
In conclusion, we continue to believe the EUR curve should be better anchored. Let’s not forget that the best environment for fixed income is positive-but-not-too-high growth, with inflation expectations in check and low default rates. That is a more accurate description of the situation in the Eurozone than in the US at the moment.