The gap between the 10-year U.S. and German government bond yields has steadied at elevated levels after a long period of widening. Why is this important? This yield spread is a barometer of the relative long-term growth outlooks and interest rates expectations in the two economies. We see room for further modest widening of the spread, reflecting better long-term growth prospects and a faster pace of monetary policy normalization in the U.S.
The relative long-term economic outlooks for the U.S. and euro-zone are major drivers of the yield spread between U.S. and German government debt. Stronger data in the U.S. has lifted confidence in the country’s long-run prospects relative to Europe. We use our BlackRock GPS to illustrate this relation: The Treasury/bund yield spread (the teal line) has tracked the economic growth expectation differentials (the dark blue line) between the U.S. and euro-zone in recent years. It has widened since late 2017 as U.S. growth expectations outpaced those of Europe, driven by anticipation of tax cuts and fiscal spending–eventually hitting the widest levels in almost three decades earlier this year. European growth data have steadied recently after downgrades to consensus estimates. Yet our GPS points to greater potential for upside growth surprises in the U.S. than the euro-zone–even as macro uncertainty rises.
Inflation and policy expectations are also key drivers of the Treasury/bund yield spread. U.S. inflation is likely to hover around the Federal Reserve’s 2% target in the near term, while euro-zone inflation is expected to stay far short of the target set by the European Central Bank (ECB), our BlackRock Inflation GPS suggests. The slippage in euro-zone inflation expectations since 2013 has helped suppress and cap European bond yields. Mirroring the gap between growth and inflation expectations, the two central banks have been on diverging policy paths. The Fed has been raising rates since late 2015 and is expected to stay on its gradual normalization path through 2019. The ECB, by contrast, is only slowly winding down its crisis-era asset purchase program, with no rate increase expected until at least mid-2019. We see this contributing to a modest further widening of U.S.-euro-zone interest rate differentials.
The supply and demand dynamics of these securities influence the spread too. The U.S. Treasury is ramping up debt issuance to fund a rising budget deficit–the result of tax cuts and spending increases. Issuance in the first seven months of this year already surpassed that of the entire 2017. This comes as Germany is reducing debt issuance. Ten-year bund supply is expected to fall nearly 20% this year. The size of the free float has shrunk to just over 10% of outstanding German bunds supply, from over 40% when the ECB started its quantitative easing program in 2015. The result: a scarcity of bunds that has put a cap on their yields.
We expect policy normalization to lead to modestly higher long-term rates in the U.S. and euro-zone, and the Treasury/bund spread to widen moderately as the Fed leads the normalization effort. The widening Treasury/bund spread reflects economic fundamentals that underpin our preference for U.S. over European equities–and could lend some support to the U.S. dollar versus the euro. Rising short-term yields price in a quarterly pace of U.S. rate hikes–and make the front end of the U.S. Treasury curve attractive for U.S. dollar-funded investors, we believe. Risks include a pause in the Fed’s rate rises due to tremors elsewhere.