LONDON, June 26 (Reuters Breakingviews) - Central banks representing four of the G7 economies, opens new tab have cut interest rates, but prices of their sovereign bonds aren’t rallying. One explanation is that geopolitical factors and fiscal worries are weighing on investors’ minds. A bigger issue is that fixed income markets are waiting for the U.S. Federal Reserve to act.
Bond traders may want to work from home a little more to avoid being taunted by their equities colleagues. Sharp increases in interest rates to fight rampant inflation in developed countries have shredded sovereign bond returns in recent years. Since 2021, an S&P Global index, opens new tab of government debt issued by developed countries lost more than 3% a year, on average. The corresponding equity index, opens new tab gained 3.6% a year, during the same period.
The start of a rate-cutting cycle would normally push yields on sovereign bonds lower, sending their prices higher. Not so far. Earlier this month, the Bank of Canada became the first central bank in the G7 to ease policy. The European Central Bank, which sets borrowing costs for G7 members Germany, France and Italy, followed suit. But the effects have been muted.
Canadian government bonds have returned less than 0.5% since the BoC cut rates on June 5, according, opens new tab to S&P Global. In Europe, yields on 10-year German debt did fall to around 2.41% from 2.54% on June 6 , when the ECB cut rates, but the shock decision by French President Emmanuel Macron to call a snap election also led to sharp rises in French and Italian yields. That mean euro zone bonds have returned, opens new tab virtually nothing since the ECB’s move.
Geopolitics and fiscal concerns are rightly dampening investors’ enthusiasm for sovereign debt. But there is another factor at play: developed countries’ bond markets are increasingly taking their cue from the United States. Since 2020, the correlation between monthly changes in 10-year government bonds issued by Germany and U.S. Treasuries of the same maturity has been nearly 0.8, according to Capital Economics, using a scale between 0 and 1. In the 1970s, it was around 0.3, while in the 1980s and 1990s, it stayed below 0.6. A correlation of 1 would imply they are moving in lockstep.
One explanation is that markets don’t trust the likes of the ECB to embark on a prolonged round of easing until the Fed does the same.
The problem, with U.S. growth and inflation still strong, is that Fed Chair Jay Powell and his colleagues have indicated they might only cut rates once this year.
“Let’s just enjoy the moment for a bit,” said BoC Governor Tiff Macklem after cutting rates. Equity investors seem to be following his advice. But unless the Fed joins the rate-cutting party, bond traders are destined to be looking on enviously from the sidelines.
The gap between the yield of France’s 10-year government bonds and German debt of the same maturity has narrowed in recent days following a sharp rise on fears about upcoming French elections. The spread between the two countries’ benchmark debt stood at around 70 basis points on June 26.
That’s much higher than the 42 basis points it had touched after the European Central Bank cut interest rates on June 6 but lower than the 83 basis points it had hit after the June 9 shock decision by French President Emmanuel Macron to call a national election for June 30 and July 7.
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