Bunds Beating Treasuries Look Set to Enjoy Spoils of Trade War

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(Bloomberg) -- As a looming global trade war spurs investors to seek shelter in government debt, one market is clearly benefiting more than others: European bonds.

Bank of America Merrill Lynch favors buying German bunds over U.S. Treasuries should President Donald Trump follow through on his tariff plans and China’s Xi Jinping retaliate. The euro-area economy’s open nature makes it vulnerable to a trade slump, which could prompt the European Central Bank to delay interest-rate increases -- boosting bonds’ appeal, according to BofAML. Algebris Investments’s Alberto Gallo also prefers to hold the region’s debt.

“If trade wars escalate and the ECB needs or wants to react, they cannot ease financial conditions through tweaking quantitative easing but will have to resort to the more traditional instrument -- that is rate-hike expectations,” said Erjon Satko, a strategist at BofAML. “We remain long euro rates versus the U.S.”

The extra yield on 10-year Treasuries over comparable bunds is currently hovering near highs last seen toward the end of 2016, largely thanks to the Federal Reserve setting off earlier on its rate-hiking cycle. Since early February, escalating global trade tensions and falling stocks have fueled haven-seeking capital flows into both German and U.S. debt, but the former has clearly outperformed.

The yield spread between 10-year Treasuries and bunds was 228 basis points on Tuesday, up from 198 at the end of 2017. The German yield has dropped 18 basis points since the end of January to 0.52 percent, while the U.S. counterpart climbed nine basis points in the same period to 2.80 percent.

ECB, Supply

ECB Executive Board member Benoit Coeure said last week that the trade spat risks increasing the burden on central banks by dimming global growth prospects. The monetary authority, which is currently considering when to halt its bond-buying program, has repeatedly warned that any unwarranted tightening of markets could delay its exit from stimulus.

There are signs that ECB officials are concerned about short-term political risks, according to Algebris’s Gallo. That could affect the timing and speed of potential rate increases next year -- which would be supportive of euro bonds, he said.

Primary-market factors may also favor European bonds over U.S. counterparts. Euro-area debt should find support this month from more than 100 billion euros ($123 billion) of scheduled redemptions that would offset issuance.

At the same time, foreign central banks and investors are rotating out of Treasuries amid rising supply and higher costs of hedging dollar exposure. Japanese investors sold a net 3.6 trillion yen ($33.7 billion) of U.S. sovereign bonds in February, the most since April 2017.

“We have been long duration in EUR since February,” said Gallo. “Trade skirmishes, global geopolitical risk and domestic political risk are all reasons for a delay in ECB normalization.”

©2018 Bloomberg L.P.

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