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March 11, 2014 5:52 pm
Differences in government borrowing costs between the UK and Germany have reached levels not seen since the late 1990s, highlighting market judgement on diverging growth and inflation prospects for the two countries.
The difference, or “spread,” between yields on 10-year UK gilts over equivalent German Bunds this week reached its highest since 1998. The US is also decoupling from continental Europe, with the spread between 10-year US Treasuries and Bunds hitting the highest since 2006.
Investment strategists said that the widening spreads reflected perceived differences in central bank policies as well as growth prospects, adding that the gap could continue to increase. Bond yields move inversely with prices.
While Mario Draghi, European Central Bank president, last week left open the option of further action to head off deflation risks in the eurozone, where growth remains weak, the Bank of England and the US Federal Reserve are moving towards tightening exceptionally loose monetary policies introduced at the height of the crisis.
“The ECB and Bank of England are on different trajectories. Draghi is saying that we are going to have exceptionally loose monetary policy for the foreseeable future, whereas members of the [UK] Monetary Policy Committee have started to talk about monetary policy normalisation in the medium term,” said Iain Stealey, senior bond portfolio manager at JPMorgan Asset Management.
“At the moment, the momentum seems to be in the spread widening further. The UK and the US still seem a long way ahead of what is happening in Europe.”
German Bund yields have fallen this month to the lowest since last July. They have edged higher since last week’s European Central Bank governing council meeting, which surprised many analysts with its failure to agree any additional policy actions to boost eurozone growth.
But markets appear unconvinced by Mr Draghi’s apparent confidence that eurozone inflation will avoid falling into a Japanese-style period of weak or negative inflation and poor economic growth.
“Markets really believe the ‘Japan-ification of the eurozone’ story – which means lower interest rates for longer. They see the probability of this happening as having increased,” said Alessandro Tentori, head of rates strategy at Citigroup.
“We have seen a decoupling in terms of timing between the Bank of England, Fed and ECB.”
The European Commission expects the UK economy to grow 2.5 per cent this year – faster than all the main eurozone economies. The spread between UK 10-year gilts and 10-year Bunds reached 117 basis points on Monday, the highest since September 1998. They rose further, to 118, on Tuesday before falling slightly.
The spread between 10-year US Treasuries and German Bunds reached 116 basis points on Monday, the highest since June 2006.
Market expectations that the ECB will be forced into fresh policy measures have been boosted this week by “dovish” comments by Sabine Lautenschläger, the German member of the central bank’s executive board. Even if the ECB does not embark on US Fed-style asset purchases, or quantitative easing, it could impose a negative interest rate on its deposit facility – in effect charging banks for parking funds overnight – which would drive market interest rates even lower.
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