Update Bonds: Yields pulled in opposite directions
US Treasury yields continued to fall this week, with ten-year yields now trading around 4.30%, down by about 25 basis points for the month. (When bond yields fall, bond prices rise.)The main reason is the string of disappointing US data over the past weeks.
The new US administration is contemplating big policy changes on many fronts, and it seems the uncertainty is starting to weigh on consumer and business confidence. Although some weakening of the US economy could be welcome in order to stay on the soft landing path (as it could help to restart disinflation), it also brings the risk of stagnation or even stagflation. Inflation expectations have been increasing, as there seems to be no end to headlines on potential tariffs. Upcoming inflation, manufacturing and jobs data will provide further information on the direction of the US economy. Unless the US economy falls off a cliff or inflation starts falling again convincingly, we expect the US Federal Reserve to stay on hold until there is more clarity regarding Trump administration policies, such clarity would likely drive US Treasury yields back up.
The direction of European yields has been less impressive. Although ten-year Bund yields are around 2.43%, which is about a 10-basis-point decline compared to last week, it is still at the same level where it started the month. The market is focused on Europe’s need to take control of its own defence capabilities, now that it seems it can no longer rely on the US. This implies a huge debt overhang that is driving up the term premium.
We don’t think markets are wrong to drive up term premiums, but we expect it to play out over a longer time frame. Even if Friedrich Merz (poised to be the new German chancellor) is successful in his ambition to form a coalition quickly and lead Europe to decisions, an improved army is not built (or bought) overnight.
We continue to expect the US to implement tariffs on Europe, which will hit European growth. This will likely force the European Central Bank to cut rates further than markets currently expect, which in the short term will then overwhelm the impact of rising term premiums. We therefore continue to prefer long duration euro-denominated bonds.