A big selloff that pushed U.S. borrowing costs to 15-year highs left euro zone bonds relatively unscathed in August, reflecting investor bets the bloc’s economic growth and funding needs will increasingly lag those in the United States.
A resilient U.S. economy and rising borrowing needs pushed Treasury yields to their highest in over 15 years in August amid growing expectations that interest rates would stay higher for longer. Furthermore, U.S. inflation-adjusted borrowing costs rose above 2% for the first time since 2009, hurting stocks and pushing up borrowing costs globally.
European bonds, however, were less affected and it is not hard to see why.
While the U.S. economy, which grew 2.4% last quarter, has delivered a string of positive surprises, sharp contractions in business activity last week pointed to deepening economic pain in Europe.
“In the U.S., we went from expectation of a recession at the end of the year to recent solid economic data,” said Mauro Valle, head of fixed income at Generali Investment Partners.
“In Europe, we went from a positive economic trend a couple of months ago to more negative data,” Valle said.
Bond markets reflect the two regions’ diverging economic fortunes and rate expectations.
Benchmark 10-year Treasury yields, though down from their highs at month-end, were still set to end August with a rise of 17 basis points, while 10-year yields have risen just 4 basis points in Germany , the euro zone’s benchmark, and by 11 bps in Britain .
Last week, U.S. 10-year Treasury yields touched their highest relative to Germany’s since December.
For rate-sensitive short-dated German bond yields yields are even down 17 bps in August as weak data has raised expectations of a European Central Bank rate hike pause in September. In contrast, equivalent U.S. yields are flat for the month.
“This is not a global selloff. It’s a U.S.-centric selloff,” said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, which manages $745 billion in assets. He said there was more focus now on individual economies and, for example, his firm favoured British government bonds.
Crucially, borrowing needs are also diverging across the Atlantic, with U.S. fiscal outlook deteriorating and euro zone’s improving.
“Europe is not paying lip service to fiscal consolidation, it is doing fiscal consolidation,” said Barclays’s head of euro rates strategy Rohan Khanna.
Fitch Ratings, which stripped the U.S. of its prized AAA credit rating in early August citing fiscal pressures, expects the U.S. government deficit to rise to 6.3% of gross domestic product this year, and 6.6% next year, from 3.7% in 2022, and widen further thereafter.
In Germany, Fitch forecasts the deficit will rise to 3.1% of GDP this year from 2.6% last year, but narrow to around 1% in the longer term. Similarly it expects deficits to narrow in highly-indebted Italy and in France.
Mondher Bettaieb-Loriet, a fund manager at Vontel Asset Management, said lower debt issuance in Europe compared with the United States, would favour European government bonds over Treasuries.
Bigger fiscal deficits lead to more borrowing, resulting in higher interest rates and lower bond prices.
BofA, Goldman Sachs and Barclays expect Treasury yields to end the year slightly below current levels. Yet last week’s Jackson Hole central banking symposium signalled growing concern that a strong U.S. economy could force the Federal Reserve to raise rates further than markets now expect, which would drive up borrowing costs elsewhere.
Barclays’s Khanna estimates German bond yields would have been 50-60 bps lower had they only been driven by domestic factors.
For now, such effect should be welcome by the ECB, helping it fight inflation by tightening monetary conditions, said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
The spillover from higher Treasury yields is more challenging elsewhere.
In Japan, rising U.S. yields have pushed the yen to its lowest in almost 10 months and Japanese bond yields touched 10-year highs, triggering a recent Bank of Japan intervention.
“The higher U.S. yields push the yen weaker, which makes it difficult for the BOJ to contain yields through bond buying,” said Ataru Okumura, senior rates strategist at SMBC Nikko Securities.