Negative Benchmark Omens – How Imminent is the Doom For Yields?

Discussion of whether [or when] there is likely to be a collapse in ‘core’ government debt prices appears to be increasing.

One example

Specifically in Europe, the question of when Bunds in general [and perhaps the Euro Bund Future contract in particular] will end their run of the last year or so, is also exercising investors.

The idea that the bull market in bonds can be safely linked to the travails of economic prospects around the world [including developments in the economic crises in Europe] does not appear to be providing complete solace to core bond investors anymore.

The worry, on the eve of the FOMC’s QE decision day, is shown in persistent talk in the market that some real money investors are switching weight out of the German benchmark and into the US one, fearing that US rates might correct first, for whatever reason.

There’s certainly no corroboration of this rumour, but the fact that the talk is out there does underline the market’s anxiety.

Clearly there is no easy solution for core sovereign investors’ worries. But still, I got to thinking…

One interesting experiment is to look at recent instances of negative spreads between the benchmarks of the two countries and compare them with what we know about strong yield spread corrections.

We know that the inverted spreads are widely postulated to be anomalous and are meant to presage all sorts of severe corrections.

We could take the 10-year UST as a basis [i.e. ‘zero’] and calculate spread values against the 10-year German benchmark .

Immediately I must caution that the idea that there’s a relationship between the inception of negative spreads and the beginning of recessions is far from straightforward and is often contested.  [‘European Central Bank Working Paper – ‘Does the Yield Spread Predict Recessions in the Euro Area?’ Fabio Moneta, 2003]

 Additionally, the ‘negative yield spread thesis’ is primarily intra-economic and not inter-economic.

There do not seem to be many precedents in attempts to draw conclusions from spread patterns between economies in different [albeit symbiotically tied] regions.

Provisos aside, let’s still have a look.

1-Year Yield Spread Comparison: 10-yr UST [Base] / 10-yr Germany

Data from FactSet Research Systems

As you can see, the spread has been negative again since February this year.

The spread was negative by 16.56bp yesterday.

But the deepest inversion this year was marked on April 3rd at -46.69bp.

Even so, compare that with May 31st 2006 when it marked -112.72bp.

It took more than a year for the spread to re-enter positive territory and it did so around mid-to-late November 2007, judging by data and the graph below.

And it took two years for the spread to correct from its depth to a peak  of +88.82bp by March 31st 2008.

10-Year Yield Spread Comparison: 10-yr UST [Base] / 10-yr Germany

Data from FactSet Research Systems

There is of course a further ‘basis’ component to consider nowadays – the base could be said to have lowered compared with the heights of the last decade.

So, if you can permit me to get ”quick and dirty”:

No one doubts that core Western benchmarks need a correction….

However, the extent to which the current ‘distortion’ is predictive of a correction [if at all] is debatable.

In other words, we may not be able to draw very close conclusions from this exercise.

What we can say with a greater degree of certainty is that the inverted 10yr UST/DE spread is unlikely to be evidence in itself of an imminent correction in yields.


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