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German Debt to Outshine Treasurys on U.S. Recovery

Wednesday, 04 April 2012 08:34 AM

Investors who reckoned German government bonds a better bet than U.S. Treasurys have pocketed a healthy profit this year and the trade offers more gains as the world's biggest economy looks set to pull ahead of the eurozone.

Brighter U.S. economic data in recent weeks led investors to favor riskier assets such as equities over safe-haven Treasurys, driving prices lower. In contrast signs that most of the eurozone was in recession and simmering tensions over the region's debt crisis supported prices of low-risk German Bunds.

This lifted the yield premium U.S. 10-year Treasury notes offer over Bunds to its highest in more than a year, at around 48 basis points, on Wednesday.

The 10-year yield gap between Treasurys and Bunds is seen as a key measure of the relative performance between two of the world's major markets for relatively risk-free government bonds and is widely traded.

The upbeat U.S. growth outlook has cooled expectations that the Federal Reserve will embark on a third round of bond purchases and fuelled expectations it may be forced to tighten monetary policy earlier than planned, a move that could be expected to push yields higher.

In the eurozone, figures this week showed its manufacturing sector shrank for an eighth month in March, with the downturn spreading from the bloc's weaker members to powerhouses Germany and France.

This gloomy outlook and abundant cash in the eurozone banking system after a 1 trillion euro ($1.314 trillion) injection of European Central Bank cash raise the prospect that German Bunds will keep outperforming Treasurys for the next six months.

The 10-year T-note yield premium over Bunds could rise as high as 75 basis points in the next three to six months, some analysts say, approaching a high of nearly 90 bps hit two years ago just before debt-laden Greece took its first bailout.

"Even though Bunds have already outperformed Treasurys by quite a bit over the last couple of months or so we very much see momentum for further widening based on the economic divergence that we're seeing," Citi strategist Jamie Searle said.

Even if German yields broke out of the 2.1-1.74 percent range they have been stuck in this year, any sell-off would be capped by the abundant ECB funds, leaving Bunds looking the better bet among core government bonds.
Searle said that with German 10-year yields at the bottom of the range, they could rise somewhat.

"But over the coming months...the risk/reward is for a further widening of that spread. Any narrowing in the differential we would take as an opportunity to add or re-enter wideners."

Investors who piled into Bunds have so far reaped more handsome returns than in Treasurys, especially against a backdrop of still ultra-low yields being offered by top-rated government bonds globally.

The total return since the end of November on German Bunds, taking account of price changes and assuming coupon payments are reinvested, stands at 5 percent, compared with almost zero on equivalent T-notes, according to Thomson Reuters Datastream.


Minutes to the Fed's March policy meeting dashed hopes of further stimulus, known as quantitative easing (QE), with the economic recovery showing signs of speeding up.

Some in the market speculate that a further improvement in U.S. unemployment data could see the Fed back down from its pledge to keep interest rates near zero until 2014. That could see U.S. T-note yields rising faster than those on Bunds.

"The opposition to QE is there and it will be quite hard to do more QE in the case of data stabilizing," said Bettina Mueller, a fund manager at DWS Investment, which has 136.5 billion euros of assets under management.

Mueller sees 10-year T-notes yielding 2.60 percent in six months, up from the current 2.25 percent with German Bund yields at 2.25 percent from 1.82 percent.

"We're a little bit short U.S. Treasurys since the beginning of the year so we are a bit cautious. Yields will probably stay quite volatile."

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Wednesday, 04 April 2012 08:34 AM
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