Historically, a peak and decline in the German 10-year Bund yield forecast a decline in the US 10-year T-Note yield. The yield on the US 10-year T-Note is a guide to bank lending rates. A second leading indicator of lending rates is the Chinese Yen peaking at a high valuation relative to the US dollar, and, subsequently falling, indicating a weakening Chinese economy.
Both Germany and China are using interest rates and currency levels to control their respective economies relative to the US economy, and therefore their exports. However, only the low in the German 10-year Bund yield consistently forecast the low in the US 10-year T-Note (see Chart I).
The reason for the sharp decline in the German 10-year Bund to a low of -40 basis points and the 2-year to -75 basis points is “the sharp slowdown in Germany’s economy to 0.7% in the 12 months through March 2019. Germany has emerged as a major victim of global uncertainties because of heavy reliance on exports, which account for 47% of its economic output, compared with just 12% for the US.”
– Wall Street Journal, July 8, 2019.
A resolution to the imbalance of trade, that favored China and Germany, would provide the opportunity for better growth in German exports in the future and a return to positive German interest rates. The current negative rates in German Bund mirrors those seen in 2016 (see Chart II).
US Nominal GDP Influence Over 10-Year Yields
US 10-year T-Note yields normally reflect nominal US GDP growth. As an example, the acceleration in nominal US GDP from 3% to almost 6% under the Trump administration increased the US 10-Year T-Note yield from around 2% to over 3%. However, the decline in the German 10-year Bund since the beginning of 2018 led to a decline in the US 10-year from over 3% to under 2%.
At the same time, world economic weakness was reflected in US nominal GDP growth declining from 5.5% to under 4% in the second quarter of 2019; a consistent indicator of US 10-year yields declining to 2%. The decline in US yields, however, is expected to result in a recovery of nominal GDP growth to 5% (given 3% real GDP and 2% inflation) by year-end 2020 (see Chart III).
The main drivers of bank profitability are (1) lending rates and (2) deposit costs. Loan rates are primarily driven by the 10-year T-Note yield and its impact on mortgage rates and business lending. The 10-year T-Note yield fell from over 3% to 2% due to the sharp decline in German 10-year yields from a +50 basis points to a low of -40 basis points. On the other hand, deposit costs are held up by a 3-month T-Bill yield of over 2% due to a Federal Funds rate of 2.5% (see Chart IV).
Bank profitability will benefit by an expected reduction in the Federal Funds rate in July 2019. Further, the low in the US 10-year T-Note yield of under 2% seems assured as the German 10-year rebounded from -40 basis points to -25 basis points recently.
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