G10 Weekly: German and US Bond Yields Are Attractive

Summary

• The European Central Bank (ECB) and the Federal Reserve (Fed) have tightened policy materially in the past year.
• As a result, bond yields across the German and US interest rate curves have risen considerably, providing opportunities for investors.

Market Implications

• Elevated German and US bond yields will attract buyers.
• Investors do not have to take on much duration risk, as even short-dated securities offer appealing yields.
• With inverted yield curves pointing to a strong probability of a recession in the euro area and US, this will make fixed income even more attractive.
• We would buy 2Y German government bonds and 6M US Treasuries.

Introduction

German and US bond yields have risen considerably in the past year, due to concerted rate rises from the ECB and Fed. The former has abandoned its negative interest rate policy (NIRP), while the latter has withdrawn from its zero-interest rate policy (ZIRP).

The reversal of NIRP and ZIRP has meant bond prices, across the German and US curves, have fallen materially, with yields rising accordingly. And while 2022 was a bad year to be long fixed income, yields are now at levels that will attract buyers in Europe and the US.

This does not mean bond yields have peaked or prices troughed, but those yields are currently at levels that were unimaginable only recently. As such, expect this to make long positions in fixed income very attractive, especially in the short ends of the curves.

The Fed and ECB Have Been Very Aggressive

Over the past year, the ECB and Fed have launched the most aggressive policy tightening since before the Global Financial Crisis (GFC) in 2007-2008. Since the GFC until 2022, both central banks had maintained accommodative monetary policy stances.

For the ECB, this meant adopting NIRP, with the central bank’s policy rate being sub-zero for seven years. For the Fed, this meant keeping its main policy rate at or near zero. For both central banks, the hyper-accommodative monetary policy stance climaxed with the pandemic stimulus.

Pandemic disruptions, together with the war in Ukraine, has led to inflation rising worldwide to levels last seen decades ago. As such, the ECB and Fed have raised policy rates to levels that predate the GFC. This has sharply raised yields across the curve.

While owning bonds has been painful over the past year, yields have now risen to levels that make them attractive to investors.

That is not to advocate an ‘all-in’ approach to bond buying. The central banks have almost certainly not finished their respective tightening cycles. Additionally, inflation is far from target in the euro area and US. Nonetheless, scaling-in to long positions now makes some sense. The yields are too attractive to ignore.

Short-End Bond Market Yields Are Particularly Appealing

Bond markets are so enticing now because investors do not need to venture too far along the curve to earn an attractive yield. The duration risk on any long fixed income position can be minimal, as is the case in Germany and the US.

Short-End German Yields

The 2-year German yield hit 3% last week for the first time since 2008.

Persistently above-target inflation readings and other strong data have driven the seemingly inexorable rise in yields. The ECB’s hawkish rhetoric has added to this, as it is particularly concerned about inflation.

Members of the ECB’s Governing Council have explicitly said they will continue with tightening monetary policy to return inflation to 2% in a timely manner.

Despite this, the 2-year yield at ~3% will attract investors. This is especially true given how quickly the move higher has occurred – less than a year ago, the German 2-year yield was sub-zero.

It is reasonable to assume that such a big move in such a short period will attract buyers.

Short-End US Yields

In the US, investors need not venture much past the 6-month part of the curve to get high yields.

The yield on a 6-month Treasury bill is over 5%, the highest since 2007.

Like in Germany, above-target inflation readings and other strong data are driving higher US yields. Like the ECB, Fed messaging has been vigilant and consistent – the central bank will stay the course to reduce inflation.

And yet, as in the euro area, the sharp and quick rise in US yields has taken the market to levels that were unimaginable this time last year. Again, this will attract buyers.

A Recession Will Make Bonds Even More Attractive

The yield curve is one of the most reliable predictors of recession. When long-term yields start to fall towards or below short-term yields, the curve flattens or inverts. This has often predicted a recession in subsequent months.

For example, the last time the US curve (2s10s) inverted was August 2019. Within six months, the global economy was in recession. Admittedly, the COVID pandemic was a big factor, but the US economy was already slowing.

Using this 2s10s metric, the shape of the curve in Germany and the US point to an elevated probability of a recession in both countries. 2s10s Germany is currently at -50bps, while 2s10s US is at -88bps.

Macro Hive’s recession model predicts a 90% probability of a US recession within 12 months.

The strong likelihood of a recession means long fixed income positions will become increasingly attractive to investors.

By that time, the ECB and Fed tightening cycles will probably be at, or near, completion. Moreover, other asset classes (e.g., equities) could become less attractive in a recession.

When combined with already appealing yields, fixed income markets will attract investors.

Conclusion

The sharp, quick rise in German and US yields in the past year make them enticing to investors. And, for any market participants who are wary of duration risk, the short-ends of the German and US curves will look particularly attractive.

The 2-year German yield is now at a level not seen since 2008, while the 6-month US Treasury bill yield is the highest since 2007. These multi-year highs, not seen since the GFC, will attract buyers.

Inverted 2s10s curves in Germany and the US point to a recession in both countries, which will make the bond markets increasingly appealing.

Given that the ECB and Fed tightening cycles are incomplete, investors will want to adopt a cautious, scaled-in approach to establishing long fixed income positions, rather than an all-in approach.

Picking the peak in yields (or the trough in prices) is a fool’s errand. Nonetheless, bonds will look attractive to market participants, who have not seen yields like this for almost a generation. We would buy 2Y German government bonds and 6M US Treasuries.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)