All Eyes on Fed After ECB Juices Up Bond Yield Divergence Trade
(Bloomberg) -- The European Central Bank’s promise to “significantly” boost the pace of bond purchases is threatening to turbo-charge a yield divergence with the U.S. that could drive money out of Europe, unless the Federal Reserve ramps up its commitment to ease policy next week.
The gap between yields on Treasuries and their German peers is already at its widest level since before last year’s pandemic meltdown in markets, reflecting the contrast between U.S. economic resilience amid a rapid vaccine rollout and Europe’s sluggish recovery. Now, strategists are warning it could widen further after the ECB pledged to ramp up the pace of quantitative easing over the next quarter, capping a nascent rise in debt yields.
That was the case on Friday -- when 10-year Treasury yields surged as much as 8 basis points to breach the key technical level of 1.60%. Those in Europe also climbed, but by less than half.
A burgeoning yield gap has several implications. Among them is the potential for investors holding European bonds to pivot into Treasuries, further boosting pressure on the ECB to step up its own purchases to keep yields in check. And now that U.S. President Joe Biden has signed off on $1.9 trillion of stimulus -- something that over the past month has boosted yields globally -- the ECB may have its work cut out for it, should the Fed hold off from a similar course of action.
“The hope is that after the next quarter the outline of the recovery will be clear enough that the economy can withstand higher bond yields,” said Antoine Bouvet, senior rates strategist at ING Groep NV, who sees the yield gap between 10-year U.S. and German bonds widening above 200 basis points from around 190 currently. “If not, then I doubt further front-loading of purchases without an increase in the total amount would be enough to suppress European rates.”
Leader to Laggard
Global bond markets have been rocked so far this year on reflation bets. But while the U.S. and the U.K.’s inoculation programs are steaming ahead, Europe still remains far behind and expectations for price rises are lagging. It’s a reversal of sorts from last year, when the region led the way in controlling the spread of the virus and providing employment support via furlough programs.
This year, European bond yields have followed those on Treasuries and gilts higher, raising concern at the ECB over choking the economic recovery before it gains traction.
At its policy meeting Thursday, ECB President Christine Lagarde vowed to boost the pace of purchases under its pandemic bond buying program over the next quarter. It’s unclear by how much, but data on Monday showed it settled 11.9 billion euros last week, well below the average pace of 18 billion euros since the tool’s inception. Credit Agricole SA expects it to climb to as high as 25 billion euros.
Within the euro area at least, there are signs that the ECB’s commitment to more bond purchases is already doing its job. German 10-year bond yields hit a three-week low on Thursday. Those in Italy plunged as much as 11 basis points to 0.57%, narrowing the yield gap between the two to 92 basis points, close to the lowest level since 2015.
The euro area’s recovery is expected to lag behind most advanced economies. Lagarde noted considerable uncertainty facing the region on Thursday, and said downside risks continue to persist in the near term.
In the U.S., meanwhile, output is expected to reach pre-pandemic levels by the middle of this year, with the recovery amplified by the wide-ranging relief package pushed by President Biden. Some of that growth is likely to translate to higher demand for goods and services from the euro area, Lagarde said, though that isn’t accounted for yet in the ECB’s latest projection of 4% growth in 2021.
The key difference between the U.S.’s package “and our massive fiscal stimulus here in Europe is that there is a bit of a time lag between the two,” Lagarde said, adding that Europe’s Next Generation EU program is “critically important” in order to help stimulate the region’s economies.
In an interview on the Boursorama website, Bank of France Governor Francois Villeroy de Galhau noted another key difference between the ECB and Fed: size.
“The size of ECB’s balance sheet in terms of GDP is twice that of the Fed’s,” Villeroy said. “So you can see we are more active.”
In stepping up bond purchases, the ECB joined the Reserve Bank of Australia, which this week pushed back against bond markets pricing in an earlier tightening of monetary policy. Investors are now honing in on the Fed’s March 17 decision to see whether it will temper expectations for a tighter stance.
“We’re starting to see those central banks who care about yields moving higher and those that are comfortable with it,” said John Taylor, a money manager at AllianceBernstein LLP. “It opens up the opportunity for that divergence or U.S. exceptionalism over the next six months or so.”
Natixis Investment Managers sees the Fed as likely to be more “forceful” and take similar steps to pressure the market, according to Esty Dwek, head of global market strategy. One way it could possibly do this is via a so-called Operation Twist, which usually involves selling shorter-dated securities to buy those further out on the yield curve, Dwek added. St. Louis Fed President James Bullard pushed back against the notion last week, saying it’s not an option right now.
Read more: ECB’s Version of Daft Punk Policy Adds to Decoupling Theme
With signs of Treasury volatility increasing, Fidelity International says the Fed may have to take similar action sooner rather than later.
“While the ECB action might help offset the unwarranted tightening to some extent, it’s ultimately the Fed that might have to step in and put the lid on the global rise in yields in a more powerful way,” wrote Anna Stupnytska, global economist at Fidelity International. “We expect this to happen at some point, particularly if market adjustment becomes more rapid and disorderly.”
©2021 Bloomberg L.P.