On the Bump in Bund Yields

Hear ye, hear ye—a momentous event occurred Wednesday: Germany’s 10-year bond yield turned positive! Just barely, and not for long—it ticked back down to -0.013% a short while later.^[i] But the brief blip above zero was enough to spark a flurry of commentary warning rising German yields would suck money out of US Treasurys, sending long rates here higher—and hurting stocks in the process. However logical that chain of events might seem, we think it has little grounding in reality.

For one, arguing a German bund yielding a whisker more than nothing will pull capital away from a US Treasury note paying 1.83% focuses too much on yields’ direction.^[ii] All else equal, money flows to the highest-yielding asset, which remains US Treasurys. The gap is wide enough that even if bunds are positive, European investors can likely still buy US Treasurys, hedge for currency risk and come out ahead. If you were managing a European pension fund and trying to balance long- and short-term obligations, which would you choose? We suspect many, if not most, would likely pick the higher-paying option.

Then again, yields aren’t static. Suppose Germany’s barely positive yield did attract a flood of buyers, who sold their US Treasury bonds. If markets are at all efficient, German yields would swiftly fall back below zero as buyers bid prices higher (bond yields and prices move in opposite directions). Bonds move on supply and demand, after all, and German bond supply is extremely tight, so it wouldn’t take much of a demand increase to tug yields lower. Meanwhile, the world would see a chance to buy Treasurys on the cheap, quickly bidding prices up and yields down and leaving everyone wondering what all the fuss was about.

Rather than focus on German and US rates in a vacuum, we suggest remembering that bond yields across the developed world tend to be highly correlated. Interest rate cycles are usually global. So the question isn’t whether incrementally higher German yields destroy Treasury demand, but whether yields globally are likely to mount a sustained climb. We have our doubts. Bond markets are forward-looking and should already reflect the upcoming end of quantitative easing (QE) in the US and the reduction of the ECB’s QE—both slated to happen in March, barring a policy shift. QE’s relationship with yields has long been of the buy the rumor, sell the news variety, with yields moving ahead of expected actions. Ditto for rate hike expectations, which is likely a big reason why since 1933, the median 10-year US Treasury yield increase after the first rate hike in a tightening cycle was less than a quarter of a percentage point after 6, 12 and 18 months.^[iii]

As for genuine forward-looking factors, the biggest influence on bond prices tends to be expected inflation. Not today’s inflation, which is hitting generational highs across the developed world—this isn’t a political statement, but based on how markets work, we think it is quite fair to say bonds already reflect the inflation we are living with today. Bonds, like stocks, reflect all widely known information. So the question is not what inflation did already, but how it is likely to evolve over the next 3 – 30 months—a window in which supply chain kinks will likely even out, investments in productive capacity will start bearing fruit, and society will get increasingly adept at living with COVID without letting it stop general economic life. Yes, money supply growth remains elevated, but much of that went to temporary transfer payments that ended up as savings or debt repayment, not excess demand. Considering yield curves aren’t all that steep globally, money velocity appears likely to stay low. All point to prices rising much more slowly, albeit off a higher base, over the next couple of years—which, in turn, points to bond yields not moving much over a meaningful length of time. That doesn’t preclude short term moves, as bonds are volatile, but it is vital that you not extrapolate the recent past across the future, as past performance just doesn’t predict.

Even if we are wrong and rates rise, that doesn’t mean much for stocks. Contrary to popular belief, there just isn’t much evidence stocks are propped up by ultra-low bond yields. If they were, you would actually see a strong negative correlation between US stocks and Treasury yields. Yet the weekly correlation between S&P 500 moves and changes in 10-year Treasury yields is actually slightly positive over the past 20 years, illustrating they move in the same direction a bit more often than not.^[iv] If yields and stocks rise together a decent amount of the time, that suggests something other than low yields is attracting investors to stocks. We have a hunch that something is a reasonably high likelihood of continued earnings growth as the world gradually emerges from the pandemic, pre-COVID economic trends return and gridlock prevents governments from doing much to mess things up. It may not be a perfect reality, but stocks don’t need perfection—just a reality that goes a bit better than the masses expect.