Yield curves: Bund or Treasuries?

Yield curves: Bund or Treasuries?

The gap between the main yield curves on either side of the Atlantic has narrowed sharply this year.

Fiscal policies have run ahead of monetary policies

Over the past five years, ten-year rates in the United States and Germany have stood at 2.80% and 1.15% respectively on average, with an average gap of 1.65% between the two yield curves. However, this gap narrowed from 2.21% to 1.47% between the beginning of the year and 7 March. This relatively impressive movement is not due, as one might usually think, to a divergence in the monetary policies of the FED and the ECB, but rather to the gap between the recent fiscal policies of these two countries. Although Donald Trump’s approach to US corporate taxation is expansionist, his policy on customs tariffs and the economic uncertainty it generates are having a detrimental effect on the country’s economy. Indeed, on 7 March, the Atlanta Fed model – which aims to estimate current US GDP growth – projected a fall of 2.4% in the first quarter of 2024. In fact, the situation has changed drastically on the other side of the Atlantic, paradoxically because of Mr Trump’s policies. While Mr Trump is sending out more and more negative signals about US involvement in the defence of Ukraine and more generally about its military support for Europe, the leaders of the new German coalition government, made up of centre-right and centre-left parties and led by the future chancellor Friedrich Merz, have announced an unprecedented set of measures that could add around 2. 5% of GDP to annual expenses. In view of these recent events, the relative movements observed on the two yield curves therefore seem entirely justified and the volatility that has set in on the market could well continue for some time yet.

The growing role of rates in the performance of a bond portfolio

Meanwhile, credit spreads continue to move at extremely tight levels. To be sure, the fundamentals largely justify this, as the balance sheets of companies and banks have been greatly cleaned up in recent years. It is also true that there remains a disparity in some credit universes that can benefit long/short credit managers who are able to bet both on the upside and the downside of the credit quality of different issuers. Nevertheless, for a more conventional bond allocation, combining sovereign bonds from developed markets and bonds from good quality companies and financial institutions, the current spread levels represent 37 basis points on an overall yield of 3.98% (all currencies combined), i.e. less than 10% of the total yield. By way of comparison, the average for the last five years was almost double that, or 19% of the total return. In view of the volatility on the various yield curves mentioned above, it is therefore essential to be cautious about exposure to them.

The importance of actively managing exposure to the various yield curves

There are many ways to build a diversified bond portfolio, whether in terms of credit risk, duration in general or exposure to different yield curves. On this last point, it may be worthwhile to focus on a flexible strategy that can adapt to changes in structural trends, as these will certainly have a historically significant impact on the performance of an overall bond portfolio exposed to US and German rates in particular.

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