Strange behaviour of US TNote and German Bund yields - Natixis

René Defossez, Research Analyst at Natixis, points out that since the start of the decade, the correlation between yields for the 10-year TNote and 10-year Bund has been very strong and this correlation is currently near 1.

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“However, as one moves towards the short end, this correlation weakens. At the short end, over the last two to three years, correlation is often negative.”

“The divergence between yields at the short end in the US and the Eurozone has been impressive. This is explained of course by the different trajectory of the monetary policies of the Federal Reserve and European Central Bank (ECB). The US central bank has started to normalise its monetary policy (Fed Funds rate has been raised three times since end-2015), with further interest rate hikes on the cards this year. As for the ECB, an interest rate hike is totally out of the question.”

“Considering the divergence in short rates, the yield spread between the 2-year TNote and Schatz stands at more than 200bp, at its widest since the start of the 2000s, the question is just how the correlation between 10-year bonds can be this strong. This is all the more surprising in that, of late, German short and long rates have also tended to diverge, which is a rare phenomenon (the slope of the German curve may rise or fall, but the trend is for all interest rates to move in the same direction).”

“One explanation of the phenomenon is the ECB’s quantitative policy, which has driven up prices considerably at the short end. The yield for the 2-year Schatz currently nears -0.80bp, which is 40bp below the ECB’s deposit rate (-0.40%). The German 2-year moved way below the deposit rate upon the ECB tweaking PSPP rules last year, when notably the yield constraint was removed. Before that, yields had to be equal to or greater than the ECB deposit rate for bonds to be eligible.”

“Amongst the consequence of this phenomenon, there is the near uninterrupted decline, over the last two years, of the 2Y-10Y box between US and German rates. This box could recover with the normalisation of the term premium in the US, but before that can happen it will probably be necessary for there to be clearer signs that the Federal Reserve is rolling back its balance sheet policy.”