No Convergence - The Spread Between U.S. Treasuries And Bunds Continues To Widen

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by: Lior Cohen
Summary

Bill Gross bet that the spread between U.S. bonds and German bund will converge.

Alas, so far the spread between the two has only widened.

What's behind this divergence and what does it mean moving forward.

The famous investor Bill Gross has suffered losses in recent months in his Janus Henderson Global Unconstrained Bond Fund. 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 presented in the figure below.

Source: FRED

Bill Gross bet that the spread between the two will eventually close (or at the very least narrow). Alas, as presented above, the spread has only widened and has already topped the 2.5% mark – a new record level.

What is behind the widening of this spread? In order to understand this divergence, it is helpful to clarify what’s moving the long-term yields of U.S. and Germany in different directions. Next, we will try to figure out what do these reasons mean for this spread moving forward.

First, even though inflation in both countries has risen, the divergence in the monetary policies of the ECB and Federal Reserve has only intensified. On the one hand, the ECB has maintained its cash rate near zero and keeps expanding its balance sheet; on the other hand, 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 rates (basically they are the central bank’s interest rates that also include other monetary policy measures – mainly quantitive easing; for the Fed, the shadow rate is roughly the Fed’s funds rate since it started to lift its cash rate).

Data source: Wu-Xia Shadow rate

The chart clearly shows that the spread between the two shadow rates has only been expanding in the past couple of years as the ECB maintains an expansionary monetary policy while the Fed has not.

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 – a tighter monetary policy in the U.S., which also means weaker demand for U.S. Treasuries, and looser fiscal policy should push up U.S. Treasuries yields or at the very least keep long-term yields in the U.S. higher than in Germany.

However, the yield curve in the U.S. continues to flatten. Shouldn’t that help close the gap between the U.S. and German bond spread? For that, I will conclude this post with one final 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? For now, that is unclear. Perhaps as long as the Fed keeps raising rates and the ECB signals tightening of its monetary policy – ending QE in late 2018 and raise rates in late 2019 -- that will be enough to keep these spreads close.

Therefore, for now, the divergence between the U.S. bond and German bund won’t change as long as the Fed keeps raising rates, the U.S. Treasury continues to issue more debt, and the ECB maintains, for now, its QE program and extremely low interest rates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.