Yield Gap

The Great Global Bond Race

  • Why it matters

    Why it matters

    The bond bull market is coming to an end after 35 years, and investors are having to rethink their portfolios.

  • Facts

    Facts

    • The yield on the 10-year U.S. Treasury bond has risen from a historic low of 1.3 percent to 2.5 percent and is expected to increase to as much as 6 percent in the next four to five years.
    • The yield on the 10-year German government bond was minus 0.2 percent last summer. Now it has reached 0.4 percent.
    • The Transatlantic yield gap is growing larger. The last time the gap was over two percentage points was more than 27 years ago.
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    Audio

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Tensions between German and U.S. bond markets are currently running high. Source: DPA

For over 35 years, bond fund managers who bet on price advances in U.S. government bonds earned a lot of money. However, the bull market for bonds with rising rates and falling yields has finally come to a close.

“If you look at the yields on 10-year U.S. bonds, which now are at 2.5 percent and more than a full percentage point higher than in the summer,  I think we’ve seen all the lows in yields for the next two years,” says Michael Krautzberger, BlackRock’s head of European fixed income.

Xueming Song, fund manager for Deutsche Asset Management, even thinks yields could be on the rise for the next 20 years. And not only in the United States but also in Germany. Only last summer, the yield on the 10-year German government bond was minus 0.2 percent. Now it has reached 0.4 percent. However, the increase hasn’t been as high as in the U.S. and the transatlantic gap is continuing to grow. The last time the gap was over two percentage points was just over 27 years ago when the markets were not as globally intertwined as they are today.

Many experts expect the difference to become even larger. “Transatlantic tensions will intensify on the bond markets,” says Alexander Aldinger, rate strategist at Bayerische Landesbank. And there are many reasons why. The U.S. economy is currently performing better than the euro zone’s, and incoming U.S. president Donald Trump has announced massive infrastructure investments with simultaneous tax reductions.

“This could give the U.S. a unique boost in growth and inflation,” explains Pioneer Investments’ head of global asset allocation research Monica Defend. And according to Tilmann Galler, chief investment strategist for JP Morgan Asset Management, growth and inflation are the arch enemies of bond investors.

For private investors who usually buy bonds to hold them to maturity, returns remain unattractive, especially in the case of German government bonds.

Its a scenario that has a palpable effect on monetary policy. This Wednesday, the Federal Reserve hiked U.S. interest rates and signaled more would follow at a faster pace next year. Goldman Sachs chief economist Jan Hatzius says he expects three interest rate hikes in 2017.

According to economists and investors, the European Central Bank on the other hand will continue to hold its benchmark refinancing rate at zero percent and is far from hitting the brakes concerning its monetary policy. On Thursday, ECB president Mario Draghi said the bank would continue its bond-purchase stimulus program as long as needed to try and keep the euro zone economy stable. According to Daniel Hartmann of Bantleon Bank AG, its likely the ECB will run the program into 2018.

In turn, differences in monetary policy also affect currencies. Most market strategists predict the euro will fall even further against the dollar. Since Mr. Trumps’s election victory in early November, the euro has again lost up to five cents against the U.S. dollar. Currently, one euro buys around $1.06. Many strategists expect the euro will hit parity for the first time since 2002.

What does this mean for investors? That depends on your perspective. For private investors who usually buy bonds to hold them to maturity, returns remain unattractive, especially in the case of German government bonds. Even “bond bears” such as Michael Heise, chief economist at Allianz, expect the return on the 10-year federal bond to be slightly above one percent at the end of next year. This is unappealing because the ECB wants to bring inflation back to about two percent in the medium term with its ultra-loose monetary policy.

The situation could already look different for U.S. government bonds next year. They could be more interesting for long-term investors if the yield on the ten-year U.S. bond would rise to 3.1 percent by the end of next year, as French bank Natixis has predicted. However, developments in currencies cannot be forecast over a ten-year period. For that reason, 10-year dollar bonds are hardly an alternative for long-term oriented private investors in the euro area.

 

Andrea Cünnen works at Handelsblatt’s finance desk in Frankfurt, reporting on the bond markets. To contact the author: cuennen@handelsblatt.com

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