The Battle of German Yields: Bill Gross vs. Eurozone Politics

The economic logic pushing German yields higher should prevail in the end, but investors need patience

By Richard Barley

German 10-year bond yield minus German consumer price inflation

Source: FactSet
Note: monthly data

Higher inflation and less central-bank stimulus should equal higher bond yields, right?

The answer has been yes in the U.S., but not in Germany, where Italian political turmoil has pushed yields lower, wrong-footing even Bill Gross. A battle that will shape markets is under way between the economic logic forcing German yields higher and the political problems weighing them down.

In one way, last week’s blow-up in Italian bonds, which sparked a rush into safer securities, gives the bet on higher German yields even more potential, as the starting point is more extreme. The thesis is simple: The deflation panic has passed, central banks will withdraw monetary stimulus in response to higher inflation, so yields on “safe” assets like Bunds and Treasurys should rise.

The European Central Bank’s chief economist Peter Praet signaled Wednesday that eurozone policymakers would debate a further step back from its bond-buying program next week. That was a surprise to investors who had thought political risk might lead the ECB to slow down.

Ten-year government bond yields

Source: WSJ Market Data Group

But while the U.S. market has followed the playbook, with 10-year yields recently reaching a near seven-year high, Germany is still way out of whack on historical measures. Janus Henderson’s Mr. Gross has been expecting the gap between German and U.S. yields to narrow.

Instead, it has kept widening to levels not seen in 30 years. 10-year Treasurys are now at 2.95% and Bunds at 0.44%.

Meanwhile, relative to domestic inflation, which stands at 2.2%, German yields are at a level seen only once before in 63 years, notes Deutsche Bank . That was early in 2017, when the ECB had yet to signal that it was thinking of starting on the long road to tighter monetary policy.

Bill Gross will need patience and a thick skin for the bet to pay off. Photo: lucy nicholson/Reuters 

But the European market is not the U.S. market. As a collection of national markets it has many moving parts with potentially conflicting policies. As Italy has reminded investors, this means politics can trump economics. Counter-intuitively, tighter ECB policy could even depress German yields if the move is seen as contributing to stress elsewhere in the bloc.

Eurozone growth will need to be solid to counterbalance that.

Ultimately, economic logic should prevail. Investors can’t indefinitely be happy with a negative real return on German bonds. But the likes of Mr. Gross need patience and a thick skin for the bet to pay off.

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