Are Risks Asymmetric For U.S.-Euro Zone Rates?

The European Central Bank’s (ECB) aggressive bond-buying program continues apace, pushing even BBB+ rated Italian bond yields well below those for U.S. Treasuries.  In Germany, AAA rated papers have negative yields until around the eight-year point on the yield curve (Figure 1).  U.S. yields are around 80 basis points (bps) higher than in Germany at the short end of the curve and about 175 bps higher at the long end despite the recent de-pricing of further Federal Reserve rate hike expectations (Figure 2).  The massive gap between U.S. and euro zone yields begs the question: what are the prospects for euro zone and U.S. fixed income markets, and are the risks for yields symmetric on both sides of the Atlantic?

Figure 1: U.S. Yields are Higher Than Even Italy’s BBB+ Rated Bonds.

Figure 2: U.S. Yields are Higher Than Euro Zone Yields Despite De-Pricing of Further Fed Hikes.

Bond returns can be functionally decomposed into two parts:

  1. Day-to-day changes in price that stem from changes in bond yields.
  2. Accumulated interest rate carry and roll-down effects: if future short-term rates rise to the level anticipated by the forward curve, carry will turn out to be zero.  If the evolution of interest rates anticipated in the forward curve is not realized, however, carry will result from two sources: A) coupon income in excess of short-term funding costs, and B) price effects of rolling down the curve.

Price risks and return asymmetries: Comparing euro zone and U.S. bonds taking into account the price and carry effects is therefore quite easy.  Regarding price effects, investors should ask themselves the following questions:

  • Is it more likely that German 2Y Schatz yields will rise 50 bps to 0 or fall an additional 50 bps to minus 100 bps?
  • Is it more likely that U.S. 2Y yields will fall 50 bps from 76 bps to 26 bps or rise 50 bps to 126 bps?
  • Are risks facing German and U.S. 2Y bond investors equally asymmetric?

The ECB won’t continue its quantitative easing program forever, and the 2013 ‘taper tantrum’ in the U.S. offers a warning on what could happen to European yields when the ECB decides at some point to bring its QE program to a close.The same question can be asked about bonds further up the curve.  For example, are German 5Y bonds (BOBL) more likely to go from a minus 30 bps yield to, say, -80 bps or rise to +20 bps?  Are U.S. 5Y bonds more likely to fall from 127 bps to 77 bps or rise to 177 bps?

Our sense is that, given the extremely low level of interest rates in Germany, the risks facing German investors are not symmetric.  In Germany, there might be a greater likelihood that yields rise by 50 bps rather than fall by the same amount.

In the U.S., it’s harder to say.  Now that Fed Funds futures have mostly de-priced further rate hikes (Figure 2), in order for short-term rates to fall further the U.S. market would have to begin to anticipate that the Fed would forgo the one rate hike that is still priced between now and the end of 2017, and that the Fed would actually contemplate taking back its December 2015 rate hike through a rate cut.

In our view, the Fed would only likely raise rates in the event of a sharp deterioration of the U.S. labor market, which so far has not happened.  For the moment, employment growth remains at around 200,000 jobs per month (or about 1.9% growth in the total number of workers).  Coupled with a 2.5% growth in average hourly earnings and a slight decline in the average number of hours worked, it implies an about 4% growth rate in total labor income – which should be plenty to underpin consumer spending even if business investment suffers because of the decline in oil prices and corporate profits begin to decline as a percentage of GDP.  That said, continued employment growth will be essential.

The recent correction in the U.S. equity market appears to be the main driver of diminished expectations for a Fed rate hike.  Much of this has been driven by energy stocks (Figure 4).

Figure 3: Total Labor Income Still Growing Steadily But Any Pullback Could Force Fed To Cut Rates.

Even if oil prices continue to fall in the U.S., it’s not entirely clear that this is bad news for investors outside of energy stocks, nor is it apparent that this will cause the Fed to delay future rate hikes to the extent priced by markets recently.  While investors’ focus has been on the decline in business investment resulting from the collapse of oil prices, it’s easy to overlook that lower oil prices is great news for consumers.  The hit to business investment, both in the U.S. oil sector as well as in oil exporting nations, tends to be felt rather quickly.  By contrast, gains to consumers and to other energy-dependent entities such as airlines and trucking companies tend to be protracted.

Figure 4: Energy Stocks Dragging Down Broader Market, Expectations Of Fed Hikes.

As such, we tend to think that U.S. rates have somewhat asymmetric upside risks, especially if equity markets stop selling off and rebound.  Nevertheless, it appears to us that the asymmetric risks regarding the future direction of bond yields are greater in Europe than in the U.S.  The ECB won’t continue its quantitative easing (QE) program forever, and the 2013 ‘taper tantrum’ in the U.S. offers a warning on what could happen to European yields when the ECB decides at some point to bring its QE program to a close.  In May 2013 when then-Fed Chairman Ben Bernanke announced that the Fed was considering tapering and eventually ending its QE program, U.S. bond yields soared, with the 10Y yield rising by 130 bps over the next four months (Figure 5).

Figure 5: U.S. Yields Soared After Taper Tantrum Announcement of May 2013.

For all of the doom and gloom about Europe, there are reasons to be optimistic:

  1. The ECB has been highly successful at compressing spreads between countries at the core and periphery.
  2. The overall level of interest rates is exceedingly low.
  3. The Euro has weakened against the U.S. dollar, adding some competitive advantage.
  4. Oil prices are low; the euro zone, which produces almost none of its own oil, is among the world’s principal beneficiaries of lower petrol prices.

Europe is undeniably at an earlier stage of its economic recovery than the U.S., but that doesn’t mean that there aren’t upside risks to bond yields and downside risks to bond prices.  What should be of bigger concern to European bond investors is that if there are downside risks to bond prices, interest rate carry and roll down will do precious little to blunt the impact.

Interest Rate Carry and Roll Down

German and Italian debt have outperformed U.S. debt so far this decade, and sometimes by wide margins.  The composition of those returns, however, has been strikingly different.   Most of the returns to investors in German bonds have come as a result of price gains stemming from the fall in yields.  As Figure 5 makes evident, German yields have fallen a great deal further than U.S. yields from a fairly similar starting point in 2010.  By contrast, the U.S., which has a much steeper curve, has been generating much greater gains from carry and roll down than the German curve.

The problem for investors going forward is this: carry and roll down have historically been much more reliable generators of bond returns than have price gains.  Price gains only occur when yields decline, and there is no guarantee that yields will decline further, especially in Europe where they are already extremely low.   One could always envision further declines: maybe the ECB will follow the lead of the Bank of Japan and Sweden’s Riksbank to put rates even deeper into negative territory.  However, the initial results from the negative rate experiment have not been encouraging.

Figures 6 through 19 show the performance comparison and decomposition of German and U.S. 2, 5, 10 and 30-year bond futures.  There are also two charts pertaining to the Italian 10-year bond future, which has become an important means of hedging sovereign default risks, and credit risks.

Figure 6: The Schatz Has Outperformed U.S.2Y since 2010.

Figure 7: Most of Schatz’s Gains Have Been From Declining Yields/Rising Prices.

Figure 8: Most Gains for U.S. 2Y Futures Have Been From Accumulated Carry & Roll Down.

Figure 9: German 5Y Futures Have Outperformed U.S. 5Y since 2010.

Figure 10: Most of BOBL Futures on OBL Gains Have Been From Declining Yields/Rising Prices.

Figure 11: Most Gains for U.S. 5Y Futures Have Been From Accumulated Carry & Roll Down.

Figure 12: German Bonds Have Also Outperformed at the 10-Year Point of the Curve.

Figure 13: Most of Bund Futures Gains Have Been From Declining Yields/Rising Prices.

Figure 14: Most Gains for U.S. 10Y Futures Have Been From Accumulated Carry & Roll Down.

Figure 15: Italian 10Y Futures the Big Outperformer After ECB Backstopped Italian Debt in 2012.

Figure 16: Italy Debt’s Gains From Carry Have Slowed With Flatter Curve; Have Substantial Credit Risk.

Figure 17: German Long Bond Futures Have Outperformed the U.S. But The Future Is Less Clear.

Figure 18: BUXL’s Outperformance Mainly Due To Yield Declines.

Figure 19: Yield Declines Have Helped U.S. 30Y But Carry Plays a More Important Role in Returns.

Bottom line: Carry and roll-down prospects are much brighter in the U.S. than in Germany or Italy.  Moreover, price risks to U.S. fixed income also may not be as asymmetric as in Germany or Italy.  As such, despite the U.S. being in a more advanced stage of its economic recovery, it’s not apparent that U.S. debt will underperform European debt.  When the ECB ends its QE program, there is a possibility that German and Italian debt will substantially underperform U.S. debt – much as U.S. debt markets underperformed their European counterparts during the taper tantrum in 2013 when the Fed announced the winding down of its QE program.

In the short-term, the ECB may be more likely to accelerate or prolong its bond purchase program given Europe’s stubborn lack of inflation and still tepid (and nascent) economic recovery.  If so, this has the potential to push the already wide U.S.–euro zone yield spreads even wider.  Nevertheless, QE can’t continue forever. Even in the meantime, carry and roll-down prospects for European bonds are, to say the least, unattractive when compared to their American counterparts.  As such, it will be much more difficult for German and Italian bond futures to outperform their U.S. counterparts during the second half of the decade, as had been the case during the first half.


All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only.  The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions.  This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

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