The expected divergence between ECB and Fed policies will bring German and US debt yields closer
German public debt is in the spotlight. Investors believe that the Federal Reserve will stop raising rates before the European Central Bank does, so they are pushing up German bond yields, bringing them closer to those of the US Treasury. Stubborn European inflation and lax German fiscal policies suggest that the differential between the two countries’ yields will continue to narrow.
The harsh words of Christine Lagarde on the 15th caught the attention of the markets. The ECB president insisted that euro zone rates must reach “restrictive” levels. The traders They now expect the deposit rate, currently at 2%, to reach 3.25% in June and stay there through 2023, according to Refinitiv data.
Fed Chairman Jerome Powell has been less convincing. The bank’s projections show the federal funds rate will rise to 5.1% in 2023, from the current 4.25-4.5%. However, investors expect rates to peak in March at 4.75% and start to decline shortly thereafter, according to Refinitiv data, as Powell is forced to prop up a faltering economy.
The diverging paths of the two banks have led to a sell-off in German sovereign bonds, sending their yields higher. The differential between the returns of the bunds 10-year and US Treasuries with the same maturity have fallen about 30 basis points since before Lagarde’s intervention, to 130 basis points, the lowest in more than two years.
Several factors point to further tightening. The first is inflation. The ECB expects core inflation, excluding food and energy, to be 2.4% in 2025, above its 2% target, due to wage growth and persistent energy prices. The Federal Reserve, for its part, forecasts core inflation of just 2.1% that year. As the price rise is likely to remain above target in Europe for some time, the ECB may have to keep rates high for longer.
The second is the rise in new German debt, aggravated by the ECB’s decision to start reducing its €5 trillion bond portfolio in March. According to estimates by Deutsche Bank analysts, in 2023, 102 billion euros in bonds net of principal payments will hit the market. This means multiplying by 10 the figure for 2022.
In total, Germany will spend some 300 billion between 2022 and 2024 to cushion the blow from rising gas prices. The stimulus will trigger inflation and force more debt to be placed, which will drive up yields. In the United States, by contrast, the blockade of Congress will keep the tax spigots closed.
The difference in yield between Treasury bonds and bunds it was around 100 basis points in 2014, before the ECB started its bond buying, and in 2012 it was flat. This suggests that there is plenty of room for the spread to narrow further.
