A look at relative bond yield spreads

At Tricio we look at charts in order to gauge investor sentiment and behaviour. There are many types of charts and chart analysis that can shed light on what is going on now, and give clues as to what may lie ahead. Bond analysts like to look at yield charts when looking at government bonds, as this gives continuity for on-the-run issues, rather than tracking each bond price or yield individually until the next auction. They also like to look at bond yield spreads to spot relative trends, which may feed into currency or other investment and trading decisions.

The charts below take a look at sovereign 10-yr. bond yield spreads over the German bund yield. Germany still has a top sovereign credit rating from the leading agencies and has served as the European benchmark for many decades.

The chart below is the weekly French 10-yr. bond yield and the spread over the German bund yield (spread in red). After recent French political events it looks like further muddling along will continue, which may last until an election has to be held in 2027. There is a chance that some sort of budget compromise will be seen before the markets reach a crisis point of course. There is also a chance that political horse trading may see the budget outlook worsen – which would be reflected by a wider yield spread.

Bond investors don’t really like uncertainty about budgets of course. This bout of spread widening started last summer and if the market loses touch with the 80 bp area on a sustained basis then 100 bp over and even the 2011 levels of 150 bp and higher may be seen.

French political parties may push market sentiment to the breaking point of course, but could back off from actually causing a crisis. Bond fund managers may also be stepping up and looking for a return to 50 bp and a bit tighter in the yield spread over time. But odds are that political certainty will be needed at some point before the spread narrows again.

There is also the idea that this card game is rigged as the ECB has their Transmission Protection Instrument up their sleeve in case markets get disorderly. This was meant to protect Italy back in 2022, and it may take some volatile and disjointed market action (with some contagion to other Eurozone bond markets) to force the ECB into considering using this tool. In theory, France would also have to be taking concrete steps to reduce their deficit before the ECB steps in. At that point it could become a Europe-wide crisis.

The next charts are meant to show that even the worst case scenarios in bond markets – when spreads over the bund yield were sky high and threatened to widen further – turned around over time in the Eurozone.

The chart below shows the Greek 10-yr. bond yield and the spread over the German bund yield. Greece was the poster child of everything that could go wrong, did go wrong in 2010-2012 and later. The yield spread is now trading below 100 bp and a new generation of bond traders will be getting used to these tight levels.

The collapse in the yield spread does mask the pain felt by bond holders during the crisis though, as they took large losses. There were also bank bailouts and a series of crisis interventions, ‘haircuts’ and rescue loans watched over by the IMF, European Commission and ECB. The Greek economy was battered for many years, and the government only resumed selling 10-yr. bonds in 2019. When governments get their finances in a deep mess, the fallout can be nasty and prolonged!

Spanish bonds (weekly 10-yr. bond yield and yield spread over the German bund yield below) were caught up in the turmoil in 2010-2012, but the yield spread is well below 100 bp here as well now and there were no haircuts. However, the collapse in the bond yield spread masks the economic pain felt in Spain during the Eurozone debt crisis and the rescue package from the ESM.

The Italian bond market (BTP yield chart and yield spread over the German bund yield below) is the one that many bond investors are used to worrying about and disruptions in this market helped draw out ECB President Draghi’s ‘whatever it takes’ speech in 2012. The Eurozone crisis hit the economy hard with a series of austerity measures implemented in 2011, though as in Spain there were no haircuts for bondholders

Bond yield spread widening over the German bund yield in 2022 prompted the ECB to magic up their TPI tool a few years ago. This bond yield spread is below 100 bp as well now.

What about other sovereign bond yields over the German bund yield? When looking at non-Eurozone or EU related bonds, fund managers typically look at domestic factors for many of their investment considerations. However, currency market participants look at yield spreads as part of their process and it may be useful to see how some bond markets are looking relative to the German bund.

The weekly chart below shows the UK gilt yield which is at pretty high spread levels over the German bund yield now. UK gilts have a reputation for being a very domestic market prone to big swings in prices and currency (GBP) which may be a factor in limiting the attraction to international investors.

Back in 2010-2012 the UK was a relative safe-haven compared to the disruption in some Eurozone bond markets. Now? Watch the 200 bp to 225 bp area as this is holding for the most part. Bond fund managers may be tempted to step in at current levels on the view that bund yields may be flat for the most part now, and gilt yields may come back to 4% (4.65% area now) over the coming quarters.

This is a leap of faith that will need to see the UK government convince the market that financial prospects (debt issuance, tax collection, economic activity, inflation) will improve. The risk is that the 225 bp area gives way on a sustained basis and 250 bp to 300 bp is seen. We prefer to think that a return to the 150 bp and potentially 100 bp area will be seen instead, but again, one may need to have faith in the ability of the government to get its act together!

The US bond market is seen as the most liquid and deepest bond market in the world and is very domestically oriented. However, the 10-yr. note yield spread over the bund yield (weekly chart below) is interesting as the spread is narrowing now. It could be that US bond yields are highlighting economic slowdown risk and steady to lower inflation outlooks. If the 150 bp area is broken on a sustained basis, 100 bp will be the next area to look for again here, supporting our view that the EUR/USD trend risk is for $1.20 to $1.25 to be seen.

Risks? There are so many! Including, once again, the risk of a federal government shutdown over the coming weeks which may concentrate credit rating agencies minds again.

Given the status of Treasuries as a risk-free asset for almost all wealth managers (and securities holders) it would need a very surprising jolt to the credit rating to really knock this.

Yield spread analysis looks at two sides of the coin. The chart analysis for the above is looking at yield spreads over the German bund yield and generally takes the view that bund yields will consolidate around 2.6% for some time. 3% may cap, and yield dips below 2% could struggle (weekly chart below).

There is a risk though that the market takes the view that the announced €500 bn of infrastructure and defence spending will boost the economy more than expected and lift bund yields above the 3% area. This would leave the 3.50% and 3.75% area as natural targets (old highs and lows) with the big risk at 4.0% for 4.70% to follow - the 2007/2008 peak.

This is not expected, but for bond fund managers if the German bund yield does rise they will have to make a difficult decision. Should the BTP (for example) continue to command a 90 bp or so spread over the bund, or could this be compressed to 20 bp or lower if the bund yield starts to rise?

Bond fund managers may have a lot on their plate over the coming year.

Gerry Celaya, Chief Strategist