European Bonds Are Starting to Curve to Inversion: Mark Gilbert
By Mark Gilbert
Oct. 12 (Bloomberg) -- The conundrum that has blurred the U.S. bond market in the past year, with short-term interest rates climbing above longer-term borrowing costs to invert the yield curve, may become a feature of Europe's fixed-income landscape.
For the first time in almost six years, the rate on benchmark euro interest-rate futures contracts has dipped below 10-year bond yields. The levels crossed two weeks ago, measured by the contract closest to settlement and the benchmark German debt security.
Two forces may combine to produce an inverted European yield curve -- and a profit bonanza for traders and investors willing to take the gamble by selling short-dated notes in favor of owning longer-term bonds. That trading strategy has paid off handsomely in the U.S. bond market in the past year.
Rampaging money-supply growth may prompt the European Central Bank to add to the five interest-rate increases it has implemented in the past 10 months, driving its main lending rate above the 3.5 percent level currently anticipated in the futures market as the peak for borrowing costs.
In the bond market, meantime, the prospect of a slowing U.S. economy will restrain yields in the Treasury bond market, which typically set the tone for government debt securities around the world. Higher ECB rates plus stable or declining bond yields could produce a curve inversion in Europe in the coming months.
``It's very possible,'' says Steve Major, head of fixed- income strategy at HSBC Holdings Plc in London. ``If the ECB keeps talking tough, that will keep short rates high, and we know that 10-year yields will follow the U.S.''
Narrowing Gap
The average gap between the near-month euro futures contract and the benchmark European bond this year is 64 basis points, with bond market levels persistently higher. The bond currently yields about 3.8 percent, while the rate on the December contract is about 3.7 percent, based on Oct. 10 end-of-day prices.
Looking at European yields, the curve is still normal; the longer you borrow for, the more expensive money becomes. Two-year yields are currently about 14 basis points lower than 10-year levels. That's down from 80 basis points a year ago, and compared with an average of 50 basis points in the past 12 months. Three- month money-market rates, meantime, are about a third of a percentage point below benchmark bonds.
Contrast that with the U.S., where the two-year note yields about 5 basis points more than the 4.75 percent available from 10-year securities, and three-month money-market rates are about 60 basis points higher than Treasuries.
`Money Versus Headwinds'
The arguments for higher ECB rates tipping the yield curve into inversion include the surprise acceleration in M3 money- supply growth to 8.2 percent in August, up from 7.8 percent in July and compared with the ECB's preferred level of just 4.5 percent.
The incentives for the central bank to pause are also considerable. They include an increase in German value-added tax, Italy's efforts to shrink its budget deficit, the European Commission's forecasting stagnant economic expansion in the first quarter of next year, plus a likely slump in U.S. growth.
``There's a tug of war between money versus headwinds,'' says Andrew Bosomworth, a fund manager in Munich for Pacific Investment Management Co., which manages the world's biggest bond fund. ``If you looked only at monetary statistics in the euro zone, you'd think the ECB is behind the curve and needs to keep hiking, that it needs to go to 4 percent or more.''
Short-Lived Independence
Set against that are the headwinds of ``the impact of past monetary policy tightening and the fiscal tightening that will come next year,'' Bosomworth says. ``You can entertain the idea of decoupling for two quarters, but there's never been a U.S. slowdown when the euro zone did not also slow down after that period.''
He expects the ECB to stop raising rates at 3.5 percent, prompting the European yield curve to flatten as the gap between short- and long-dated borrowing costs shrinks. ``Those headwinds, though, will prevent an inversion,'' he says.
In July 2005, Alan Greenspan put bond traders and investors on notice that the U.S. central bank's monetary-policy strategy was likely to push short-term interest rates above longer-term borrowing costs. The Federal Reserve would ``continue to remove monetary accommodation,'' the then Fed chairman said.
He also said he wasn't worried by the prospect of an inverted yield curve, even though it had previously had an impeccable record of presaging economic recessions. The yield curve's ``efficacy as a forecasting tool has diminished very dramatically,'' he said.
At the time, the two-year Treasury was yielding about 3.95 percent, while the 10-year note offered 4.25 percent. Six months later, the two securities flipped into inversion.
Inflation Outlook
In Europe, ECB President Jean-Claude Trichet said this week that ``monetary policy in the euro area remains accommodative.'' He also said ``it will remain warranted to further withdraw monetary accommodation'' if growth and inflation turn out the way the central bank is forecasting.
The ECB expects inflation to be about 2.4 percent this year and next, outpacing its 2 percent target.
The June 2007 contract currently has the highest rate in the futures market at 3.87 percent. That suggests traders and investors are betting that the ECB has just one more interest- rate increase to go before pausing with its main lending rate at 3.5 percent. If they're wrong, the European bond market is likely to replicate the shift seen in U.S. Treasuries.
``Even if the ECB policy makers stop at, say, 3.75 percent, they're institutionally more hawkish than the Fed,'' says HSBC's Major. ``They'll make sure the forward curve is pricing something with a `4' handle.''
(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Mark Gilbert in London at
[email protected] .
