Trumpflation vs Negative Rates: The Battle Endures

Monetary policy continues to determine the path for bond markets

By Richard Barley

The big focus for bond markets is on U.S. fiscal policy under President Donald Trump. But investors need to keep in mind that global monetary policy remains a potent force, even if it isn’t grabbing the headlines like it used to. The bond bear trade has a gravitational drag outside the U.S.

To see that, just look at Germany, which Tuesday issued a new two-year note at a record low yield of minus 0.92%—a remarkable development given rising eurozone inflation and continued growth momentum. Investors posted bids of nearly €7.3 billion for the €5 billion note.

German yields have declined in part because of jitters about elections in the eurozone, particularly in France, that could pose a threat to the currency bloc’s survival. Those fears have ebbed a little in recent days, with the gap between French and German yields narrowing.

But German yields have also been driven lower by changes made to the European Central Bank’s bond-purchasing program. In particular, the decision to allow purchases of bonds yielding less than the ECB’s deposit rate of minus 0.4% has put sharp downward pressure on yields on short-dated German bonds that were previously excluded from purchases. This is potentially a more powerful and longer-lasting force than election nerves: a real debate about the ECB tightening policy looks a way off in the eurozone. Some strategists, such as those at Citigroup and ING, think two-year German yields could push to minus 1% or below.

That has ripple effects. The German yield curve steepened sharply last year but the move has lost momentum. Two-year yields are helping to anchor 10-year yields, which stand at just 0.2%. Along with yield curve control in Japan —where the Bank of Japan Tuesday set out a detailed schedule of purchases in an effort to reduce volatility in bond yields—that is fuel for a continuing search for yield elsewhere in global markets. That may help explain why the U.S. Treasury bond bear trade has been stuck in a rut, with yields moving broadly sideways for three months.

Central banks may have reached the end of the road in terms of loosening policy further. But as long as they are in no hurry to tighten policy, these bond-market tensions look likely to persist.

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