DM Government Bonds Diverging
Bottom Line: Growing views of a soft landing in the U.S. in contrast to increasing H2 EZ/UK recession fears are the key drivers behind the widening of 10yr U.S. Treasury spreads during the summer. Some further widening may be seen into the autumn, as remaining ECB tightening fears are overdone and the market discounts more 2024 ECB rate cuts. 10yr UK-Bund spreads can also remain elevated, though will likely narrow into 2024. Finally, BOJ caution is restricting any adjustment of 10yr JGB yields and the spread will likely consolidate at the current elevated levels, given the soft landing story in the U.S. stops too much of a further reversal in U.S. yields.
As DM policy tightening nears a peak, 10yr government bond spreads are starting to diverge.What is driving this and how much further can they diverge?
Figure 1: 10yr U.S. Treasury-Bund Spread and Fed Funds-ECB Depo Rate (%)
Source: Datastream/Continuum Economics
U.S. Soft Landing and EZ/UK Recession
A widening of the 10yr U.S. Treasury to Bund spread has been evident over the summer and the main reason is the divergent real sector view. Economists have been shifting towards a U.S. soft landing view after the late Q2/early Q3 real sector numbers, in contrast to EZ data that has prompted fears of a recession in the EZ – we see this starting in Q3 (here). Meanwhile, the summer U.S. economic data has tempered thoughts of aggressive 2024 Fed rate cuts. In contrast, the Eurozone debt market was worried that the ECB would hike the deposit rate to 4.25%, but is now not even fully discounting that a 4.00% deposit rate will be delivered in the coming months and actually a cut to 3.50% ECB deposit rate is nearly discounted for the July 24 ECB meeting. The coming months will likely see a EZ recession confirmed; that ECB rates have already peaked and prospects increasing for 2024 ECB rate cuts to avoid a deeper recession and a 2025 undershoot of the inflation objective. In contrast, a U.S. soft landing leaves the Fed sustaining high rates and hawkish communications into 2024, as it waits for slow progress on core PCE inflation coming back down to 2%. This argues for some further 10yr spread widening by U.S. Treasuries to the 170bps region into the autumn.
One question is whether the recent Fitch downgrade of the U.S. has also had an impact on the 10yr spread? In itself we would argue perhaps not, as most EZ countries have a lower credit rating than the U.S. and the U.S. government debt/GDP ratio is on only a gently rising trend. However, some EM countries are trying to diversify away from U.S. Treasuries either for portfolio returns or alternatively to avoid the risk of U.S. sanctions in a geopolitical crisis (after Russia FX reserves were frozen with the invasion of Ukraine). A bigger issue for us is Fed QT, which is persistent and larger in scale than the ECB APP QT operations and likely to remain so through 2024 given the ECB commitment to keep on reinvesting the PEPP portfolio until 2025.
For the UK, the 10yr premium over U.S. Treasuries has also narrowed over the summer. The May/June fears that the BOE would have to hike bank rate to 6% given the worse core and wage inflation than the U.S. have been tempered and the market discounts two more 25bps hikes to a peak of 5.75%. However, the 10yr Gilt-Bund spread has remained just below 200bps, as the market is less confident in core or wage inflation in the UK coming down to be consistent with 2% inflation target on a 24 month than for the EZ/ECB. The gap of UK wage and core inflation above the EZ is unlikely to narrow quickly in the coming months (though headline inflation differential will with UK headline CPI inflation set to fall towards 5% in October due to large energy base effects). This will likely mean that the 10yr Gilt-Bund spread could remain elevated into the autumn around 200bps.While we see the UK recession as being slightly worse than the EZ in H2 2023, this is not sufficient to trigger a big change of view on UK rates or yields. It would require the UK recession to be much deeper than the EZ, which is a risk given the scale of BOE tightening but is not yet our central scenario.
However, into 2024 the disinflationary process will likely come through forcefully in the UK, with labor market data showing a bigger deterioration than the U.S. or EZ and this should curtail wage and core inflation and allow the BOE to cut rates by 50bps in 2024.
Figure 2: 10yr UK-Bunds Spread and BOE Bank Rate-ECB Deposit Rate (%)
Source: Datastream/Continuum Economics
The summer has seen 10yr U.S. Treasury-JGB yield spreads widen, as the disinversion of the U.S. yield curve and soft landing ideas have been more important that the BOJ changes to QE YCC. Though the 10yr JGB yield cap is now at 100 bp, intermittent bond-buying means that the effective cap is at 0.65% 10yr JGB yields. We can see the BOJ allowing 10yr JGB yields to rise to 0.75% into the early autumn, but this will not materially reduce the spread in itself. BOJ Governor Ueda remains cautious at heart and does not want to use the full flexibility of a 1% yield cap. This BOJ caution could be challenged into 2024, if Japan headline and core inflation remains well above 2%.This would likely mean a narrowing to the 250-350bps 10yr U.S. Treasury-JGB spread evident in the 2003-07 period (Figure 3). However, our forecasts remains that the latter post-COVID reopening in Japan has boosted inflation (still evident in the GDP data) but that this will ebb into 2024, while wage inflation will also likely move to a lower rate reflecting remaining disinflationary tendencies among households. This downside surprise on Japan’s inflation is more of a 2024 story however and will likely stop an additional changes to QE with YCC.
Figure 3: 10yr U.S. Treasury-JGB Spread (%)
Source: Datastream/Continuum Economics
This means that the 10yr U.S. Treasury-JGB spread will likely be dominated by U.S. yield movements in the coming months. The last few days has seen some of the U.S. 10yr yield surge since mid-July being partially reversed, due to some soft notes among the U.S. data releases. 10yr yields are now more appropriate given the inverted yield curve and prospects of the Fed doing one last hike in November. Thus we look for a choppy profile of 10yr U.S. Treasuries-JGB’s around current levels.