Bonds Reflect Hope That U.S. Recovery Will Spread to Europe -- Update

By Paul J. Davies and Anna Hirtenstein

The gap between U.S. and European 10-year government bond yields has tightened to its narrowest in more than a month as Treasurys rallied and German bunds sold off in recent days.

The move signals that investors are changing their views about the relative performance of the two economies: The strong recovery of the U.S. has been priced in and a pickup in Covid-19 vaccinations in Europe is raising hopes that the summer will bring better growth there, according to investors and analysts.

U.S. 10-year yields ticked down to 1.596% on Tuesday, having dropped from a peak close of 1.744% at the end of March, according to Tradeweb. German 10-year yields were at minus 0.243%, up from minus 0.381% in late March and close to their peak close of minus 0.233% in late February. Yields fall when bond prices rise and vice versa.

The fall in Treasury yields has come despite strong economic data from the U.S. showing an improving labor market and rising inflation. Such data would usually prompt a rise in bond yields as investors move funds out of safe assets.

"The market has been trying to figure out what was priced in, and investors have realized that a lot of the good news was already there," said Steve Englander, head of global FX research and North America macro strategy at Standard Chartered. At the same time, he said investors have "shifted from all-out euro pessimism to ordinary euro pessimism."

The gap between U.S. and German 10-year yields shrank from a peak of 2.04 percentage points on March 31 to less than 1.84 percentage points Tuesday, according to Tradeweb.

Konstantin Veit, portfolio manager at Pimco, said while many European countries were still in lockdown, vaccinations were accelerating toward what he expects to be top speed by mid-May.

"The European economy is still largely closed, but the period of stronger data is expected to be around the corner," he said.

Hopes for an improving outlook and the rise in European yields has some investors questioning whether the European Central Bank will signal any change in its policies after its interest-rate setting meeting on Thursday. Inflation expectations have picked up for the region, but Mr. Veit said that wasn't enough to spark a change of policy.

"I wouldn't expect European yields to back up considerably from here, given the ECB's inflation outlook is still below target, meaning financing conditions are too tight at the current level," he said.

However, technical characteristics of market positioning and flows may have also helped drive the move in yields.

One thing potentially pushing eurozone yields higher is the ECB not buying as many bonds each week as the market expected, though it said in March that it would accelerate the purchase program in part to ward off tightening credit conditions in the region.

Demand for business loans in the eurozone fell and banks tightened credit standards in the first quarter of this year, according to the ECB's latest lending survey released Tuesday. That may deal a blow to the bloc's slow economic recovery.

At the same time, investors have large short positions in European government bonds futures, or bets that European yields will still rise, according to David Bieber, quantitative analyst at Citigroup.

This contrasts with positioning in Treasury futures, where investors have been taking profits on long-held bets against U.S. bonds since the recent peak in yields, drastically cutting back what had been the biggest short positioning since about 2005, Mr. Bieber said.

"Short positions in Treasurys have more than halved," he said. "There are still big short positions in eurozone bonds...shorts have declined a little but they are still very extended."

Plenty of uncertainty remains for both U.S. and eurozone yields due to the spread of new strains of Covid-19, which may or may not be more resistant to vaccines. Any sign that vaccines don't work as well as hoped would likely see yields fall in both markets as investors seek refuge in the safest assets.

"On a global basis, we're still seeing record new [Covid-19] cases," said Peter Schaffrik, global macro strategist at RBC Capital Markets. "It's unclear how mutations will react to vaccines, so it's still a question mark, we'll have to see."

The diminishing gap between U.S. and eurozone yields has implications for currencies too, and is one good explanation for the fall in the dollar since the end of March. The ICE Dollar Index, which tracks the greenback against a basket of currencies, is down 2.4%. The dollar has lost 2.8% against the euro.

"The loss of upward momentum [in U.S. yields] has taken away the main driver for a strong dollar in the near term," said Lee Hardman, FX strategist at MUFG.

Write to Paul J. Davies at [e-mail] and Anna Hirtenstein at [e-mail]

(END) Dow Jones Newswires

04-20-21 1053ET