Bond Market Tilts Toward Frankfurt as Draghi Negates Fed’s Hawks

By Liz Capo McCormick and Susanne Walker

Photographer: Bradly Boner/Bloomberg

Bond yields across the euro area, from Germany to France and Spain, have tumbled to... Read More

The world’s most-influential bond market might just be in Frankfurt.
As speculation deepens the European Central Bank will start quantitative easing just as the Federal Reserve ends its own bond buying, Europe is gaining more leverage over investors globally as the specter of deflation in the region unleashes greater demand for fixed income. The gravitational pull exerted by German bunds may blunt any jump in yields as the Fed moves to lift U.S. interest rates for the first time since 2006.
None other than Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said on Aug. 20 the direction of 10-year German bunds sets the “tone” for investors. A day later, Citigroup Inc. cut its yield forecasts for U.S. Treasuries on weakening growth and inflation expectations in Europe after German yields fell below 1 percent.
“Developments in the euro area are causing long-term rates to be lower all over,” Amitabh Arora, the New York-based head of interest-rate strategy at Citigroup, one of 22 primary dealers that trade directly with the Fed, said in a telephone interview on Aug. 25.
Arora anticipates that yields on 10-year Treasuries will end the year at 2.8 percent from 2.34 percent yesterday. He trimmed his call from 2.95 percent after the New York-based firm’s economics team predicted the ECB will start a 1 trillion-euro ($1.3 trillion) asset-purchase program by December to keep consumer prices from falling as the region’s economies sputter.

Taking Cues

Bond yields across the euro area, from
Germany to France and Spain, have tumbled to records since ECB President Mario Draghi said at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming, on Aug. 22 that the bank will use “all the available instruments needed to ensure price stability” and is “ready to adjust our policy stance further.”
Yields on the 10-year bund fell to 0.88 percent, the lowest in the euro region, while France’s benchmark note dropped to 1.25 percent. Spain’s 10-year bond yields ended at 2.25 percent -- below those of comparable U.S. notes.
The growing influence of the ECB also means more investors are taking cues from the $1.5 trillion German debt market -- rather than the $12.2 trillion market for Treasuries -- to find out where bonds globally are headed.
As 10-year German yields fell below 1 percent last month for the first time, similar-maturity securities in the U.S., the U.K. and Canada were moving more in tandem with bunds than at any time this year, data compiled by Bloomberg show.

Deflation Risk

On the day the Fed released minutes of its July meeting, Gross, who runs the $223 billion Pimco Total Return Fund, said on Twitter that 10-year bunds set the “global market tone.”
Worsening economic conditions in Europe may now bolster the case for more stimulus when the ECB meets on Sept. 4, depressing yields further. The inflation rate in the 18-nation euro region fell to 0.3 percent in August, the lowest in five years, data from the European Union’s statistics office showed Aug 29.
As recently as January 2013, living expenses were rising faster than the ECB’s target rate of just under 2 percent.
Germany, Europe’s largest economy, shrank 0.2 percent in the second quarter, while France’s stagnated and Italy fell back into a recession, separate reports showed last month.
“The European financial system and economy is a huge portion of the developed world,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in a telephone interview on Aug. 26. The ECB “is a very powerful central bank that drives investment dollars.”

Yield Gap

With yields already so low in Europe, speculation the ECB will finally embrace a form of monetary stimulus it has long avoided has also been a boon for bonds outside the region.
Debt securities of all types worldwide returned 1.3 percent in August, the most since January, according to index data compiled by Bank of America Merrill Lynch.
“There’s a push for yield and it’s having an effect” on bond demand around the world, Matthew Eagan, a fund manager at Loomis Sayles & Co., which oversees $231 billion, said in a telephone interview on Aug. 27.
In the U.S., where yields on 10-year Treasuries exceeded comparable bunds by the most since 1999, those on the benchmark note decreased by the most in seven months as investors took advantage of the yield premium.
The prospect bond yields will get dragged lower as the ECB moves to loosen monetary policy is helping drown out some Fed officials who have pushed for faster U.S. rate increases.
Last month, St. Louis Fed President James Bullard said monetary policy may be tightened earlier than officials previously expected.

Rate Alarms

Philadelphia Fed President Charles Plosser went further, saying the central bank should be signaling that rate increases may come sooner and waiting too long to lift borrowing costs risks triggering inflation and disrupting financial markets.
Traders are now pricing in a 51.5 percent chance the Fed will boost rates in July, from 63 percent a month ago, data compiled by Bloomberg show.
Bond buyers risk overlooking the strength of the U.S. recovery, which will compel the Fed to raise its benchmark rate and prove to be more important than anything the ECB does, said Wilmer Stith, a Baltimore-based fund manager at Wilmington Trust Investment Advisors, which oversees $14 billion.
The world’s largest economy rebounded from its worst drop-off in five years by expanding at a 4.2 percent rate in the second quarter, government data showed last week.
And while forecasters have repeatedly slashed their yield forecasts for Treasuries this year as everything from the harsh winter to uneven labor growth and geopolitical unrest caused investors to pile into U.S. debt, they still anticipate 10-year yields will end at 2.92 percent this year.

Pulling Teeth

That’s more than a half-percentage point higher than where they now stand, data compiled by Bloomberg show.
“There’s going to be a lot more pulling of teeth in terms of when that first hike takes place,” Stith said by telephone Aug. 26. “But at the end of the day, it’s the economy, and that’s going to be the driver” of higher bond yields.
Mark MacQueen, a partner at Sage Advisory Services Ltd., which oversees $11 billion, says slowdown in the euro region, whose economies are collectively almost 40 percent larger than China’s, may hold back U.S. growth and keep Fed Chair Janet Yellen from siding with the bank’s more hawkish policy makers.
About 40 percent of this year’s decline in traders’ expectations this year for where yields on five-year Treasuries will be in 2019, which influences the outlook for the 10-year note, has been due to euro-area concerns, Citigroup estimates.
“If you get deflation in Europe and global growth slows, Yellen will have trouble finding a good reason to raise rates,” MacQueen said by telephone Aug. 26 from Austin, Texas.