ERIK NORLAND, SENIOR ECONOMIST AND EXECUTIVE DIRECTOR
CME GROUP
Euro Zone Versus U.S. Rates:
Asymmetric Risks?
All examples in this report are hypothetical interpretations of situations and are used for explanation
purposes only. The views in this report reflect solely those of the author and not necessarily those
of CME Group or its affiliated institutions. This report and the information herein should not be
considered investment advice or the results of actual market experience.
Figure 1: U.S. Yields are Higher Than Even Italy’s BBB+
Rated Bonds.
Fed Funds Futures December 2016 and 2017
2.5
2
1.5
1
Dec-17
0.5
0
Dec-14
Bond Yields and Composite Ratings
Dec-16
Mar-15
May-15
Jul-15
Sep-15
Dec-15
Feb-16
Source: Bloomberg Professional (FFZ6 and FFZ7)
3.00%
2.70%
Yield to Maturity as of March 1, 2016
Figure 2: U.S. Yields are Higher Than Euro Zone Yields
Despite De-Pricing of Further Fed Hikes.
100 - Fed Funds Futures Price
The European Central Bank’s (ECB) aggressive bond-buying
program continues apace, pushing even BBB+ rated Italian
bond yields well below those for U.S. Treasuries. In Germany,
AAA rated papers have negative yields until around the eightyear point on the yield curve (Figure 1). U.S. yields are around
80 basis points (bps) higher than in Germany at the short end
of the curve and about 175 bps higher at the long end despite
the recent de-pricing of further Federal Reserve rate hike
expectations (Figure 2). The massive gap between U.S. and
euro zone yields begs the question: what are the prospects for
euro zone and U.S. fixed income markets, and are the risks for
yields symmetric on both sides of the Atlantic?
2.50%
2.51%
USA: AAA
Italy: BBB+
2.00%
1.31%
1.50%
1.62%
0.84%
1.38%
1.00%
0.50%
0.90% Germany: AAA
0.31%
0.35%
0.15%
0.00%
-0.06%
-0.18%
-0.50%
-0.54%
-0.39%
-0.57%
-1.00%
3M Bill
2Y
5Y
10Y
30Y
Source: Bloomberg Professional (WBCV, ED1 and ER1)
1
1) Day-to-day changes in price that stem from changes in
bond yields.
2) Accumulated interest rate carry and roll-down effects:
if future short-term rates rise to the level anticipated by the
forward curve, carry will turn out to be zero. If the evolution
of interest rates anticipated in the forward curve is not
realized, however, carry will result from two sources: A)
coupon income in excess of short-term funding costs, and
B) price effects of rolling down the curve.
Price risks and return asymmetries: Comparing euro zone
and U.S. bonds taking into account the price and carry
effects is therefore quite easy. Regarding price effects,
investors should ask themselves the following questions:
•
Is it more likely that German 2Y Schatz yields will rise 50
bps to 0 or fall an additional 50 bps to minus 100 bps?
•
Is it more likely that U.S. 2Y yields will fall 50 bps from 76
bps to 26 bps or rise 50 bps to 126 bps?
growth rate in total labor income – which should be plenty
to underpin consumer spending even if business investment
suffers because of the decline in oil prices and corporate
profits begin to decline as a percentage of GDP. That said,
continued employment growth will be essential.
Figure 3: Total Labor Income Still Growing Steadily But
Any Pullback Could Force Fed To Cut Rates.
Total Labor Income =
Ave. Hourly Earnings x Ave. Hours Worked x # of Workers
6.0%
Total Labor Income
4.0%
Year on Year % Growth
Bond returns can be functionally decomposed into two parts:
Average Hourly Earnings
2.0%
Number of Workers
0.0%
Hours Worked
-2.0%
-4.0%
Are risks facing German and U.S. 2Y bond investors
equally asymmetric?
Our sense is that, given the extremely low level of interest
rates in Germany, the risks facing German investors are not
symmetric. In Germany, there might be a greater likelihood
that yields rise by 50 bps rather than fall by the same amount.
In the U.S., it’s harder to say. Now that Fed Funds futures
have mostly de-priced further rate hikes (Figure 2), in order
for short-term rates to fall further the U.S. market would
have to begin to anticipate that the Fed would forgo the one
rate hike that is still priced between now and the end of 2017,
and that the Fed would actually contemplate taking back its
December 2015 rate hike through a rate cut.
In our view, the Fed would only likely raise rates in the event
of a sharp deterioration of the U.S. labor market, which so
far has not happened. For the moment, employment growth
remains at around 200,000 jobs per month (or about 1.9%
growth in the total number of workers). Coupled with a 2.5%
growth in average hourly earnings and a slight decline in the
average number of hours worked, it implies an about 4%
2008
2009
2010
2011
2012
2013
2014
2015
2016
The recent correction in the U.S. equity market appears to be
the main driver of diminished expectations for a Fed rate hike.
Much of this has been driven by energy stocks (Figure 4).
Figure 4: Energy Stocks Dragging Down Broader
Market, Expectations Of Fed Hikes.
S&P 500 versus S&P 500 Energy Sub-Index
800
2500
S&P
500
2000
700
600
500
1500
S&P 500 Energy
Sub Index
1000
400
300
200
500
100
0
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
0
Bloomberg Professional (SPX and S5ENRS)
Even if oil prices continue to fall in the U.S., it’s not entirely
clear that this is bad news for investors outside of energy
stocks, nor is it apparent that this will cause the Fed to delay
future rate hikes to the extent priced by markets recently.
While investors’ focus has been on the decline in business
2
S&P 500 Energy Sub-Index
The same question can be asked about bonds further up
the curve. For example, are German 5Y bonds (BOBL) more
likely to go from a minus 30 bps yield to, say, -80 bps or rise
to +20 bps? Are U.S. 5Y bonds more likely to fall from 127
bps to 77 bps or rise to 177 bps?
2007
Source: Bloomberg Professional (AWH TOTL, AHE YOY%, NFP T)
S&P 500
•
-6.0%
investment resulting from the collapse of oil prices, it’s easy
to overlook that lower oil prices is great news for consumers.
The hit to business investment, both in the U.S. oil sector as
well as in oil exporting nations, tends to be felt rather quickly.
By contrast, gains to consumers and to other energydependent entities such as airlines and trucking companies
tend to be protracted.
Europe is undeniably at an earlier stage of its economic
recovery than the U.S., but that doesn’t mean that there
aren’t upside risks to bond yields and downside risks to bond
prices. What should be of bigger concern to European
bond investors is that if there are downside risks to bond
prices, interest rate carry and roll down will do precious
little to blunt the impact.
As such, we tend to think that U.S. rates have somewhat
asymmetric upside risks, especially if equity markets stop
selling off and rebound. Nevertheless, it appears to us that
the asymmetric risks regarding the future direction of bond
yields are greater in Europe than in the U.S. The ECB won’t
continue its quantitative easing (QE) program forever, and
the 2013 ‘taper tantrum’ in the U.S. offers a warning on what
could happen to European yields when the ECB decides at
some point to bring its QE program to a close. In May 2013
when then-Fed Chairman Ben Bernanke announced that the
Fed was considering tapering and eventually ending its QE
program, U.S. bond yields soared, with the 10Y yield rising by
130 bps over the next four months (Figure 5).
Interest Rate Carry and Roll Down
Figure 5: U.S. Yields Soared After Taper Tantrum
Announcement of May 2013.
U.S. and German 10Y Yields
4.5
4
2013 "taper tanrtum" in U.S. could be repeated in
Germany when the ECB one day announces the end of QE.
Yield to Maturity
3.5
3
2.5
2
U.S. 10Y
Treasury
1.5
1
0.5
0
2010
German 10Y
Bund
2011
2012
2013
2014
2015
2016
Source: Bloomberg Professional (GTDEM10Y and USGG10Y)
German and Italian debt have outperformed U.S. debt
so far this decade, and sometimes by wide margins. The
composition of those returns, however, has been strikingly
different. Most of the returns to investors in German bonds
have come as a result of price gains stemming from the fall in
yields. As Figure 5 makes evident, German yields have fallen
a great deal further than U.S. yields from a fairly similar
starting point in 2010. By contrast, the U.S., which has a
much steeper curve, has been generating much greater
gains from carry and roll down than the German curve.
The problem for investors going forward is this: carry and roll
down have historically been much more reliable generators
of bond returns than have price gains. Price gains only occur
when yields decline, and there is no guarantee that yields will
decline further, especially in Europe where they are already
extremely low. One could always envision further declines:
maybe the ECB will follow the lead of the Bank of Japan and
Sweden’s Riksbank to put rates even deeper into negative
territory. However, the initial results from the negative rate
experiment have not been encouraging.
Figures 6 through 19 show the performance comparison and
decomposition of German and U.S. 2, 5, 10 and 30-year bond
futures. There are also two charts pertaining to the Italian
10-year bond future, which has become an important means
of hedging sovereign default risks, and credit risks.
Figure 6: The Schatz Has Outperformed U.S.2Y
since 2010.
Reinvested (Rolled) Futures Returns
107
For all of the doom and gloom about Europe, there are
reasons to be optimistic:
2) The overall level of interest rates is exceedingly low.
3) The Euro has weakened against the U.S. dollar, adding
some competitive advantage.
January 1, 2010 = 100
1) The ECB has been highly successful at compressing
spreads between countries at the core and periphery.
German Schatz
106
105
U.S. Two Year
104
103
102
101
100
4) Oil prices are low; the euro zone, which produces almost
none of its own oil, is among the world’s principal
beneficiaries of lower petrol prices.
99
2010
2011
2012
2013
2014
2015
2016
Source: Bloomberg Professional (DU1 and TU1, rolled 5 days prior to expiry using ratio method)
3
Figure 7: Most of Schatz’s Gains Have Been From
Declining Yields/Rising Prices.
Figure 10: Most of BOBL Futures on OBL Gains Have
Been From Declining Yields/Rising Prices.
Schatz Future Rolled Return Decomposed
Bobl Future Rolled Return Decomposed
0.07
0.25
0.06
0.2
Log Growth of a Euro
Log Growth of a Euro
0.05
0.04
0.03
0.02
0.15
0.1
0.01
0.05
0
-0.01
2010
2011
2012
2013
Interest Rate Changes
2014
2015
0
2010
2016
2011
Carry/Rolldown
2012
2013
Interest Rate Changes
Source: Bloomberg Professional (DU1, GTDEM2Y, GETB1), CME Economic Research Calculations
2014
2015
2016
Carry/Rolldown
Source: Bloomberg Professional (OE1, GTDEM5Y, GETB1), CME Economic Research Calculations
Figure 8: Most Gains for U.S. 2Y Futures Have Been
From Accumulated Carry & Roll Down.
Figure 11: Most Gains for U.S. 5Y Futures Have Been
From Accumulated Carry & Roll Down.
U.S. 5Y Future Rolled Return Decomposed
U.S.2Y Future Rolled Return Decomposed
0.25
0.07
0.06
Log Growth of a Dollar
Log Growth of a Dollar
0.2
0.05
0.04
0.03
0.02
0.15
0.1
0.05
0.01
0
2010
2011
2012
Interest Rate Changes
2013
2014
2015
0
2016
2010
2013
2016
Reinvested (Rolled) Futures Returns
170
German OBL
German Bund
160
125
January 1, 2010 = 100
120
115
2015
Carry/Rolldown
Figure 12: German Bonds Have Also Outperformed at
the 10-Year Point of the Curve.
Reinvested (Rolled) Futures Returns
130
2014
Source: Bloomberg Professional (FV1, USGG5YR, GB3), CME Economic Research Calculations
Figure 9: German 5Y Futures Have Outperformed U.S.
5Y since 2010.
January 1, 2010 = 100
2012
Interest Rate Changes
Source: Bloomberg Professional (TU1, GB3, USGG2YR), CME Economic Research Calculations
U.S. Five Year
110
105
100
95
2010
2011
Carry/Rolldown
150
140
130
U.S. Ten Year
120
110
100
2011
2012
2013
2014
2015
Source: Bloomberg Professional (OE1 and FV1, rolled 5 days prior to expiry using ratio method)
2016
90
2010
2011
2012
2013
2014
2015
2016
Source: Bloomberg Professional (RX1 and TY1, rolled 5 days prior to expiry using ratio method)
4
Figure 13: Most of Bund Futures Gains Have Been From
Declining Yields/Rising Prices.
Figure 16: Italy Debt’s Gains From Carry Have Slowed
With Flatter Curve; Have Substantial Credit Risk.
Bund Future Rolled Return Decomposed
Euro-BTP Future Rolled Return Decomposed
0.5
0.6
0.45
0.5
0.4
0.35
Log Growth of a Euro
Log Growth of a Euro
0.4
0.3
0.25
0.2
0.15
0.1
0.2
0.1
0
0.05
0
-0.05
0.3
-0.1
2010
2011
2012
2013
Interest Rate Changes
2014
2015
-0.2
2016
Carry/Rolldown
2010
2011
Source: Bloomberg Professional (RX1, GTDEM10Y, GETB1), CME Economic Research Calculations
Figure 14: Most Gains for U.S. 10Y Futures Have Been
From Accumulated Carry & Roll Down.
2014
2015
2016
Carry/Rolldown
Figure 17: German Long Bond Futures Have
Outperformed the U.S. But The Future Is Less Clear.
U.S. 10Y Future Rolled Return Decomposed
Reinvested (Rolled) Futures Returns
230
German BUXL
0.3
210
0.25
January 1, 2010 = 100
Log Growth of a Dollar
2013
Source: Bloomberg Professional (IK1, GTITL10Y, GETB1), CME Economic Research Calculations
0.35
0.2
0.15
0.1
0.05
0
2012
Interest Rate Changes
190
170
U.S. Ultra Long
150
U.S. Long Bond
130
110
2010
2011
2012
2013
Interest Rate Changes
2014
2015
90
2016
Carry/Rolldown
2010
2011
2012
2013
2014
2015
2016
Source: Bloomberg Professional (RX1,US1, WN1, rolled 5 days prior to expiry using ratio method)
Source: Bloomberg Professional (TY1, USGG10Y, GB3), CME Economic Research Calculations
Figure 15: Italian 10Y Futures the Big Outperformer
After ECB Backstopped Italian Debt in 2012.
Figure 18: BUXL’s Outperformance Mainly Due To
Yield Declines.
BUXL Future Rolled Return Decomposed
Reinvested (Rolled) Futures Returns
0.8
Italian Ten Year
170
0.7
160
0.6
Log Growth of a Euro
January 1, 2010 = 100
180
150
140
130
U.S. Ten Year
120
110
0.4
0.3
0.2
100
90
80
2010
0.5
0.1
2011
2012
2013
2014
2015
Source: Bloomberg Professional (IK1 and TY1, rolled 5 days prior to expiry using ratio method)
2016
0
2010
2011
2012
2013
Interest Rate Changes
2014
2015
2016
Carry/Rolldown
Source: Bloomberg Professional (UB1, GTDEM30Y, GETB1), CME Economic Research Calculations
5
Figure 19: Yield Declines Have Helped U.S. 30Y But
Carry Plays a More Important Role in Returns.
US Long Bond Future Rolled Return Decomposed
0.6
Log Growth of a Dollar
0.5
0.4
0.3
0.2
0.1
0
-0.1
2010
2011
2012
2013
Interest Rate Changes
2014
2015
2016
Carry/Rolldown
Source: Bloomberg Professional (WN1, USGG30Y, GB3), CME Economic Research Calculations
Bottom line:
Carry and roll-down prospects are much brighter in the U.S.
than in Germany or Italy. Moreover, price risks to U.S. fixed
income also may not be as asymmetric as in Germany or
Italy. As such, despite the U.S. being in a more advanced
stage of its economic recovery, it’s not apparent that U.S.
debt will underperform European debt. When the ECB ends
its QE program, there is a possibility that German and Italian
debt will substantially underperform U.S. debt – much
as U.S. debt markets underperformed their European
counterparts during the taper tantrum in 2013 when the Fed
announced the winding down of its QE program.
In the short-term, the ECB may be more likely to accelerate
or prolong its bond purchase program given Europe’s
stubborn lack of inflation and still tepid (and nascent)
economic recovery. If so, this has the potential to push
the already wide U.S.–euro zone yield spreads even wider.
Nevertheless, QE can’t continue forever. Even in the
meantime, carry and roll-down prospects for European
bonds are, to say the least, unattractive when compared to
their American counterparts. As such, it will be much more
difficult for German and Italian bond futures to outperform
their U.S. counterparts during the second half of the decade,
as had been the case during the first half.
6