Analysis: Europe’s Weaker Economy Limits Fallout of US Bond Rout

By Yoruk Bahceli

A significant selloff in the U.S. bond market has driven borrowing costs to their highest levels in over 15 years, but euro zone bonds have remained relatively stable in August. This indicates that investors believe the economic growth and funding needs in the euro zone will fall further behind those of the United States.

The U.S. economy’s resilience combined with increased borrowing requirements caused Treasury yields to climb steeply in August, reflecting expectations that interest rates will remain elevated for an extended period. Additionally, inflation-adjusted borrowing costs in the U.S. surpassed 2%, the highest level since 2009, negatively impacting stock markets and contributing to rising global borrowing costs.

Conversely, European bonds have shown less volatility, which can be attributed to contrasting economic indicators from both regions. While the U.S. economy posted a growth rate of 2.4% last quarter, recent reports showed significant declines in business activity in Europe, signaling worsening economic conditions.

Mauro Valle, head of fixed income at Generali Investment Partners, noted the shift in expectations: “In the U.S., we went from anticipating a recession at the end of the year to seeing solid economic data,” he remarked. “In Europe, we have seen a transition from positive trends a few months ago to increasingly negative data.”

The disparity in economic performance and interest rate outlooks is evident in the bond markets. Benchmark 10-year Treasury yields, although slightly lower at the end of August, recorded a rise of 17 basis points for the month. In contrast, 10-year yields in Germany, the euro zone’s benchmark, increased only 4 basis points, and British yields rose by 11 basis points.

Meanwhile, short-term German bond yields have fallen by 17 basis points this month due to weaker economic data, which has heightened expectations of a pause in rate hikes by the European Central Bank. U.S. short-dated yields have remained flat.

Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, emphasized the localized nature of the recent selloff, stating, “This is not a global selloff. It’s a U.S.-centric selloff,” noting a shift towards focusing on individual economies, including a preference for British government bonds.

A crucial factor driving this divergence is the differing fiscal outlooks on either side of the Atlantic. “Europe is actively pursuing fiscal consolidation, not just paying lip service to it,” said Rohan Khanna, head of euro rates strategy at Barclays.

Fitch Ratings has downgraded the U.S. from its AAA credit rating due to fiscal pressures, projecting the U.S. government deficit to rise to 6.3% of GDP this year, increasing to 6.6% in the following year from 3.7% in 2022. By contrast, Germany’s deficit is anticipated to rise to 3.1% of GDP from 2.6% last year, but is expected to narrow towards 1% in the long term.

Mondher Bettaieb-Loriet, a fund manager at Vontel Asset Management, noted that lower debt issuance in Europe compared to the U.S. favors European government bonds over Treasuries. Greater fiscal deficits correlate with more borrowing, leading to higher interest rates and falling bond prices.

Looking ahead, financial institutions like BofA, Goldman Sachs, and Barclays expect Treasury yields to decline slightly by year-end. However, insights from last week’s Jackson Hole central banking symposium indicated mounting concerns that a robust U.S. economy may compel the Federal Reserve to raise rates more than anticipated, which could elevate borrowing costs in other markets.

Khanna from Barclays mentioned that if German bond yields were influenced solely by domestic factors, they would likely be 50-60 basis points lower. Presently, the effect of U.S. yields may aid the ECB in its efforts to combat inflation by tightening monetary conditions.

The repercussions from rising Treasury yields are creating challenges elsewhere, particularly in Japan, where increasing U.S. rates have depressed the yen to its lowest value in nearly 10 months. As a result, Japanese bond yields have peaked at 10-year highs, prompting intervention from the Bank of Japan. Ataru Okumura, senior rates strategist at SMBC Nikko Securities, remarked, “The higher U.S. yields weaken the yen, complicating the BOJ’s attempts to stabilize yields through bond purchases.”