When tapering was announced by the Federal Reserve (Fed) in May last year, one reaction which caught my attention was the strong positive correlation maintained between the 10-year US Treasury and Bund yields (the latter being a representative of the euro one risk-free rate).
For many such a relationship was obvious and correct, given that both instruments are ‘AAA’ rated and very frequently used as the long-term risk-free rate in their respective currencies. However, what is also true is that these two instruments were subject to macroeconomic scenarios which were (and are more so today) very different. More importantly, the difference is not reflective (in my opinion) of a short-term blip in statistics, but the result of a real, structural economic difference between the US and Europe.
In May 2013, Fed chairman Ben Bernanke felt the need to start a new communications thread with the market titled ‘tapering’ (even though his term was going to expire a few months later). The improvement in the underlying economic data the Fed was analysing called for this communication to commence without delay. It is also important to bear in mind that at the same time ECB president Mario Draghi was seeing a very different picture in theeurozone – a picture which only called for more accommodative talk with respect to monetary policy.
However, in July 2013, just two months after the tapering announcement, the spread between the 10-year US Treasury yield and the 10-year Bund yield did start to widen.
Today, eight months later, the spread between the yields of these two instruments is almost the widest it has ever been since the start of the euro (similar spreads were seen when the euro as a single currency was launched and then again in 2005 and 2006). In my opinion this spread is set to widen even further.
Historically, US and European monetary policies have been very synchronised, reflecting the economic and financial linkages between the two. However, going forward this may not remain the same. The reasons for this are several, but they all originate from the same fundamental starting point: the US economy is moving forward whereas the European economy is, at best, moving sideways.
Let us start from unemployment. Primarily it was the improvement in this statistic which caused the Fed to start tapering. The economic stimulus provided by the Fed was successful to the extent that fewer people were claiming to be jobless as job creation started picking up.
Secondly, a strengthening labour market will, at some point, start putting upward pressure on wages which will not be matched by greater output resulting in inflation. By the time the consumer price inflation rate starts approaching the Fed’s target rate of two per cent (which is currently 1.2 per cent in the US vs the 0.5 per cent in the eurozone) we should witness a substantially wider yield spread between these two risk-free instruments.
Within this statement I am also assuming that not enough time would have passed to see Europe (as a whole) advancing economically as a result of structural reform. The primary reason for this assumption is the fact that the ECB has been (and is still) lagging behind other central banks in expanding its balance sheet and aggress-ively spearheading this economic crisis. The EU Commissioner for Employment, Social Affairs and Inclusion, Laszlo Andor, has just stated, following the release of the most recent unemployment data, “the social situation in the EU shows little signs of improvement. Inequalities have risen and the situation of many households and individuals is not improving, with ever-growing numbers suffering from financial distress”.
The high unemployment figures together with signs of slower output are signs that a self-sustaining recovery is not yet in place within Europe. Such an economic scenario will only increase the likelihood of further stimulus from the ECB, while the Fed motors ahead with its tapering programme.
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This article is the objective and independent opinion of the author. The information contained in the article is based on public information.
Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Karl Micallef is an executive director at Curmi and Partners Ltd.