By Daniel Kruger and Anchalee Worrachate
Jan. 11 (Bloomberg) -- The correlation between Treasuries and German bunds that has prevailed since credit markets started freezing in 2007 is breaking down as U.S. economic growth leaves Europe behind.
Yields on U.S. 10-year Treasury notes rose twice as fast as German debt with a similar maturity since the start of December, according to data compiled by Bloomberg. The bonds had traded almost in tandem since April 2007 as investors sought a refuge from the first global recession in six decades and then shifted to higher-yielding assets in 2009.
Pacific Investment Management Co., FAF Advisors Inc. and Fischer Francis Trees & Watts, who oversee more than $1.1 trillion, are buying bunds and selling U.S. debt to profit as the markets decouple. Strategists say Treasuries may post a second year of losses in 2010 because Federal Reserve Chairman Ben S. Bernanke will raise interest rates as America’s gross domestic product increases 2.6 percent while Germany’s expands 1.9 percent, Bloomberg surveys show.
“We’re going to continue to see this differentiation,” said Timothy Palmer, a money manager who helps oversee currencies and international debt in Minneapolis at FAF, which has $15 billion invested in taxable bonds. “Our view has been to be favorably disposed to European bonds over the U.S.”
Pimco Buys Bunds
Pacific Investment has accumulated the equivalent of $20 billion of bunds in the past month for its flagship Pimco Total Return Fund, Bill Gross, the co-chief investment officer at the Newport Beach, California-based firm, said in a Bloomberg Radio interview on Jan. 8. That’s about 10 percent of the fund’s $204 billion in assets, he said.
Yields on 10-year U.S. notes climbed 45 basis points to 3.83 percent since the Labor Department said on Dec. 4 that U.S. employers cut the fewest jobs since the recession began. Comparable yields on bunds, the benchmark for the 16 countries that share the euro, rose 21 basis points to 3.39 percent.
The difference in yields grew to as much as 0.49 percentage point last month, the most since July 2007. The gap narrowed 2 basis points to 0.45 percentage point on Jan. 8 after the December jobs report showed U.S. employers unexpectedly cut 85,000 positions. The Labor Department also revised the November figure to a gain of 4,000 jobs, the first increase since the recession began in December 2007.
Europe’s unemployment rate jumped to 10 percent last month, the highest in more than 11 years, according to the European Union statistics office. Economists expected 9.9 percent, after the 9.8 percent initially reported for October, a Bloomberg survey showed.
Profit Potential
Ten-year Treasury yields were little changed at 3.83 percent last week, while comparable bund yields were steady at 3.39 percent.
Trading of Treasuries was closed in Japan today for a holiday. Bunds hadn’t started changing hands as of 1:09 p.m. in Tokyo.
JPMorgan Chase & Co.’s head of European interest-rate strategy in London, Pavan Wadhwa, expects the U.S. yield will reach 4.1 percent by June 30 while the rate on bunds declines to 3.35 percent. An investor who sells $10 million of Treasuries and bets on bunds would earn a profit of about $210,000 if the forecasts are right, excluding currency fluctuations.
The firm’s weekly index measuring sentiment toward Treasuries fell to minus 15 on Jan. 4, the most bearish reading since March 2007. Back then, 10-year U.S. yields were just beginning to rise, surging as much as 0.75 percentage point to 5.32 percent by mid-June of 2007.
Declining Correlation
Treasuries lost 1.32 percent last quarter, while bunds returned 0.13 percent, including reinvested interest, according to Bank of America Merrill Lynch indexes. The 44-day correlation coefficient fell to 0.54 on Jan. 8 from a three-year high of 0.76 on Nov. 19. A value of one would mean U.S. and German 10- year yields moved in lockstep.
Decoupling became a favored term for investors and economists before credit markets seized up when they predicted a U.S. slowdown wouldn’t curtail expansion in Europe, Asia and Latin America. Instead, when the U.S. economy contracted 1.9 percent in 2008, German GDP fell 1.8 percent and Japan’s shrank 4.1 percent.
With economies emerging from the first global recession since World War II, investors say the U.S. will improve faster than Europe. U.S. GDP likely increased 3 percent last quarter, compared with a drop of 1.85 percent in Germany, according to the median estimates of economists surveyed by Bloomberg.
Reducing Stimulus
Euro-area growth will be restrained as governments reduce stimulus measures and unemployment rises, three research institutes said last week. GDP in the region probably rose 0.3 percent in the fourth quarter from the third, Germany’s Ifo institute, Italy’s Isae and France’s Insee said Jan. 8.
“As the data flows through and we put together two consecutive quarters of 4 to 4.5 percent GDP, there’s going to be a period toward the end of the first quarter where it’s going to be looking fairly sustainable,” said David Tien, a money manager at Fischer Francis in New York who helps oversee $19 billion. “The trend right now of a stronger U.S. is getting on track and definitely has room to run.”
Even investors who question the strength of the U.S. recovery favor bunds. Pimco’s Gross, who said Jan. 8 that America’s economy is still too fragile for the Fed to back away from its stimulus measures, reduced the Total Return Fund’s holdings of government-related securities to 51 percent in November from a five-year high of 63 percent in October. The firm doesn’t break down the data according to sovereign issuers.
‘Shaking Hands’
Before paring government debt, Gross had said Pimco bought Treasuries with the proceeds of mortgage-backed debt sales to the Fed as part of the firm’s “shaking hands with the government” strategy. That’s when the central bank embarked on so-called quantitative easing programs, acquiring assets including mortgages and government securities to reduce borrowing costs and stimulate growth.
The Fed and U.S. agencies have lent, spent or guaranteed $8.2 trillion to lift the economy from the worst recession since the Great Depression, data compiled by Bloomberg shows. The Treasury sold a record $2.11 trillion in notes, bonds and inflation-linked securities last year.
“German bonds are basically yielding the same as U.S. Treasuries and their programs have not been quantitative-easing- oriented,” Gross said in a Jan. 6 Bloomberg radio interview. “You move to a country where fiscal conservatism and the lack of check writing have taken place.”
Fiscal Divergence
U.S. yields will grind higher because America’s fiscal outlook will remain weak for the next several years, Gross said. That contrasts with Germany, where a constitutional amendment has mandated a balanced budget by 2016, he said.
Treasury 10-year yields may rise 30 to 40 basis points by May, causing the gap between bunds and U.S. notes to widen to 100 basis points or more from the current 45 basis points, Gross said. A basis point is 0.01 percentage point.
Treasury yields will rise more than bunds because the European Central Bank’s sole focus on fighting inflation will cause ECB President Jean-Claude Trichet to raise interest rates faster than Bernanke, according to Kommer van Tright, head of interest rates at Rotterdam-based Robeco Groep NV.
The ECB’s main refinancing rate has been 1 percent since May, while the Fed’s target for overnight loans between banks has been in a range of zero to 0.25 percent in December 2008.
“The Fed is more likely to be behind the curve than the ECB as they might hold rates lower for longer for the sake of improving the labor market or overall economic conditions,” said van Tright, who’s firm manages $180 billion.
‘Relative Strength Game’
German 10-year yields averaged 0.27 percentage point less than Treasuries the past decade, and 0.06 percentage point below comparable U.S. debt in the 1990s.
The gap widened to as much as 1.20 percentage points in October 2005 as the Fed increased rates. It began to shrink in mid-2006, with bunds yields eventually exceeding those on Treasuries by 0.88 percentage point in December 2008 as investors rushed for the safety of America’s debt in the wake of Lehman Brothers Holdings Inc.’s collapse three months earlier.
That’s also after the Fed said it was considering buying Treasuries to keep borrowing costs from rising and to revive credit markets.
“It’s a relative strength game that’s going on,” said George Goncalves, chief fixed-income rates strategist in New York at Cantor Fitzgerald LP. “This can last for a while but it won’t last forever.”
To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net.
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