Mind the yield gap

Diverging interest rates lure speculators into US bonds, denting the euro

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A signal on interest rates? Source: Getty Images

Financial markets are a bit flummoxed about going-ons in the world economy. Nothing reflects that confusion more clearly than the growing gap in yields between government bonds in the United States, the leading global market, and the euro zone.

By rights, America’s booming economy and the Federal Reserve’s policy of gradually but steadily raising its benchmark overnight rate should be pushing up the yields, or annual returns, on US Treasuries. No less a personage than JPMorgan CEO Jamie Dimon said this week that yields currently should be at 4 percent, and are more likely to get to 5 percent than most people realize.

And yet the yield on the 10-year Treasury bond remains stubbornly below 3 percent. For one thing, Mr. Dimon is fairly alone in his assessment about yields. The announcement of bigger Treasury auctions in the coming months to keep pace with the growing US deficit did cause a brief spike in yields to 3 percent. But they have since retreated as global investors shift funds into the US currency because even at 3 percent, the yields are much better than elsewhere.

Divergence encourages “currency carry trade”

Better than in Germany, for instance, and in most other euro-zone countries. Yields on the 10-year German government bonds, also known as Bunds, are only slightly above zero. At more than 2.5 percentage points, the differential between the 10-year paper in Germany and the US is wider than at any time since the 1990s (see graphic below). This creates its own problems because it increases the flow of funds out of the euro and into the dollar.

Nor is this likely to change. The Fed remains steady on its course of raising rates, while the European Central Bank has said its earliest rate increase will be more than a year from now. Prospects of a growing divergence between the policies of these two central banks are motivating hedge funds and other speculators to engage massively in “currency carry trades.” This means borrowing funds in euros at virtually zero interest and investing them in dollar-denominated bonds with returns near 3 percent. These trades can rake in so much money that even a sudden reversal in exchange rates poses little risk.

Christoph Rieger, a German analyst at Commerzbank, frets that this development will hit US stocks, because investors will find the bond yield more attractive and safer than dividends from stocks. But Mr. Dimon himself prophesizes that the US bull market could go on another two or three more years, thanks to a strong economy and higher corporate profits boosted by lower taxes.

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Everyone seems to agree that such a divergence in interest rates cannot last in a global economy. “No economic region can decouple itself from the world in the long run,” said Jörg Warncke at Union Investment. “In the long term, interest rates in the US and Germany will converge.”

For this reason, the legendary bond investor Bill Gross is positioning himself for a decline in US yields and an increase in German yields — the exact opposite of Mr. Dimon’s expectations. Mr. Gross has been wrong before, which is one of the reasons he is now at Janus Capital and no longer at Pimco, an erstwhile tiny investment firm that he built into a bond powerhouse. But it may be that an active and experienced trader like Mr. Gross wins out over a bank manager like Mr. Dimon, no matter what his economists are telling him.

Jakob Blume covers financial markets for Handelsblatt and Andrea Cünnen covers investing and bond markets. Darrell Delamaide is a writer and editor for Handelsblatt Global in Washington, DC. To reach the authors: blume@handelsblatt.com, cuennen@handelsblatt.com, and d.delamaide@extern.handelsblatt.com

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