The famous investor Bill Gross has received some negative publicity as his Janus Henderson Global Unconstrained Bond Fund suffered heavy losses in recent months. The prime reason behind these losses is the bet his fund made over the growing spread between U.S. Treasuries and German bunds; this spread – for the 10-year bonds — is shown in the figure below.
Source: FRED
As you can see, the spread has already topped the 2.5% mark – a new record level and doesn’t seem to be slowing down.
What is behind this spread? In order to understand this spread, it is helpful first to understand what’s moving each of these bond yields and why this divergence is happening. Next, we will try to figure out what’s do these issues mean for this spread moving forward.
First, the U.S. long-term treasuries have been picking up for several reasons. While inflation in both countries has risen, the divergence in the monetary policy has only intensified. While the ECB has signaled a slower pace for purchasing bonds as part of its QE program, the Federal Reserve has been slowly reducing its balance sheet and raising interest rates. To demonstrate this divergence, I include the following graph of the shadow rate (basically it is the central bank’s interest rate that also includes other monetary policy tools – mainly QE – to stimulate the economy.
Data source: Wu-Xia Shadow rate
The chart clearly shows that the spread between the two shadow rates has only been widening in the past several years.
Second, the fiscal policy of the two countries is also an issue that is likely to keep the spread wide. The widening of the spread may continue because while the Germans aren’t expanding this deficit and keep their debt levels low, the U.S. has passed a budget that will only balloon its budget deficit; this deficit will require the Treasury to issue more long-term bonds to finance it.
Putting these two issues together – the tighter monetary policy, which also means weaker demand for U.S. Treasuries, and looser fiscal policy should only push up U.S. Treasuries yields.
However, the yield curve continues to flatten. Shouldn’t that help close the gap between the U.S. and German bond spread? For that, I will conclude with my last chart.
Source: FRED
This chart shows that the spreads of the 10 years to 3 months of both German and U.S. bonds have been moving in the same direction in the past year or so. In fact, they are currently pretty close – perhaps the closet they have been in years. Will this convergence last? That’s unclear. Perhaps as long as the Fed keeps raising rates and the ECB signals of changing direction on its monetary policy in the coming months (e.g., ending QE), that will be enough to keep these spreads close.
Therefore, for now, it seems that the spread between the U.S. bond and German bund won’t converge as long as the Fed keeps raising rates and the U.S. Treasury continues to issue more debt all awhile the ECB maintains its QE program and extremely low interest rates.