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By Breakingviews
German government debt is in the firing line. Investors reckon the Federal Reserve will stop hiking rates before the European Central Bank, and so are pushing up yields on German bonds, bringing them closer to those of U.S. Treasuries. Europe’s stubborn inflation and Germany’s lax fiscal policies suggest the spread between the two countries’ yields will narrow further.
Christine Lagarde’s tough words on Dec. 15 got the markets’ attention. The ECB president insisted that eurozone rates must reach “restrictive” levels. Traders now expect the deposit rate, currently at 2%, to reach 3.25% in June and remain there throughout 2023, according to Refinitiv data.
Fed Chair Jerome Powell has been less convincing. The bank’s projections show the federal funds rate climbing to 5.1% in 2023, up from the current 4.25% to 4.5%. Yet, investors reckon that rates will peak in March at 4.75% and start falling shortly after that, according to Refinitiv data, as Powell is forced to prop up a faltering economy.
The two banks’ diverging paths sparked a sell-off in German sovereign bonds, which pushed their yields higher. The spread between yields on 10-year bunds and U.S. Treasuries of the same maturity has fallen some 30 basis points since before Lagarde spoke to 130 basis points, the lowest in more than two years.
Several factors point to further narrowing. The first is inflation. The ECB predicts that “core” inflation, which excludes food and energy, will be 2.4% in 2025, above its 2% goal, due to wage growth and lingering energy prices. The Fed meanwhile projects core inflation at just 2.1% that year. With price rises likely to stay above target in Europe for some time, the ECB may have to keep rates elevated for longer.
The second is a surge in new German debt, compounded by the ECB’s decision to start reducing its 5 trillion euro bond portfolio in March. That will lead to 102 billion euros of bunds hitting the market in 2023 net of principal payments, Deutsche Bank analysts estimate. That’s a 10-fold increase in 2022.
In all, Germany will spend around 300 billion euros between 2022 and 2024 to cushion the blow from higher gas prices. The stimulus will boost inflation and mean more debt has to be placed, both pushing up yields. But in the United States, congressional gridlock will keep the fiscal spigots shut.
The yield gap between Treasuries and bunds was around 100 basis points in 2014 before the ECB began its bond-buying, and in 2012, it was flat. That suggests there’s plenty of scope for the spread to narrow further.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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