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Recent changes in sovereign yields put under the microscope

Since the start of the year, yields for the 10-year TNote and Gilt have been more or less the same. At the same time, the yield spread between Bund and its UK and US counterparts has widened by 100bp, and is now not far off 150bp.

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Since the start of the year, all yields have eased, but the decline in the Bund’s yield far exceeds the declines recorded by the TNote and Gilt. At 0.866%, the yield for the 10-year Bund sits at a new all-time low.

We believe that our approach will bear up to scrutiny, as we propose observing the behaviour of break even inflation rates and real rates. We are lobbing 68bp off Gilt breakeven inflation rates, which corresponds to the historical differential between inflation as measured by the RPI and by the CPI. This provides inflation benchmarks that are rather more comparable. The chart below shows that breakeven inflations for index-linked Gilts and TIPS have oscillated between 2% and 2.25% over much of the period concerned (save at the start of last year), which in light of past inflation levels in the US and US is not aberrant. On the other hand, breakeven inflation for the 10-year Bund€i has shed more than 50bp and is way off historical inflation levels in the Eurozone (the Bund linker is indexed to Eurozone inflation, but this is not really problematic in that this inflation is closely correlated to German inflation).

The chart above already provides one quite clear indication, which is that the downturn in Eurozone inflation expectations is due mainly to the decline in German long nominal rates.

Observing real yields for 10-year linkers reveals that they have inched lower in Germany, down 10bp, that they have been stable in the UK, and that they have increased by 80bp in the US since the start of 2013.

Real yields therefore explain to a small extent the decline in German nominal yields. They explain nothing in the UK and are up 80bp in the US.

On first analysis, the above provides the following indications:

  • 1. Bund is being bolstered both by strong demand (safe haven status, Eurozone current account surplus, etc.) and by the downturn in inflation expectations (which yesterday’s data will do nothing to alter, as German inflation reached 0.8% in August, whereas Spanish inflation moved into negative territory).
  • 2. The rise in the TNote yield over the period is due to its “real” component, in part offset by the “inflation” component. The deflation risk in not an issue in the US. Having said that, this rise in 10-year real yields has merely seen it recover to zero percent, which is extremely low by past standards. In the case of the US, as with Germany, there is strong demand for govies, which is protecting them partly from the reorientation of monetary policy.
  • 3. Real yield for the Gilt is stable, but deep into negative territory, for the same reasons. The deflation risk in not an issue in the UK also.

The downturn in inflation expectations, which is specific to the Eurozone, therefore seems to go a long way towards explaining Bund’s outperformance.

René Defossez , September 2014

Article also available in : English EN | français FR

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