Bundesbank Reacts to Weakness in German PMI
The Central Bank of Germany, or Deutsche Bundesbank, historically adjusts asset purchases of bunds and other assets to change the direction of the yield on 10-Year bunds. This is used in an attempt to alter the course of the German economy, because of the weakness in the Purchasing Managers Index (PMI) for manufacturing. In Germany, exports of goods represent 47% of GDP.
In 2015 the German PMI was stagnant, which resulted in the Bundesbank allowing the 10-Year bund yield to peak at 80 basis points and fall to a negative 16 basis points. Subsequently in 2016, German PMI recovered above the previous year’s high and the Bundesbank allowed the 10-Year yield to rise to a positive level. Another peak and decline in the PMI occurred in early 2018, followed by the PMI falling to a new low of 41.4 in 2019, causing the Bundesbank to make adjustments again. As a result, this yield fell to a negative 73 basis points by early September 2019.
The US 10-Year T-Note yield has mirrored the movement in the German 10-Year since 2014. This paradigm was disrupted in 2018 due to the aggressive increase in the federal funds rate, which widened the yield spread between US Treasuries and German bunds. When the US PMI also fell significantly in 2019, the US 10-Year yield collapsed (see Charts I & II).
US Manufacturing PMI and T-Note Yields
Historically, as seen from 2009 to 2013, the US 10-Year T-Note yield mirrored the US PMI for manufacturing. However, beginning in 2013, the correlation broke down and the German 10-Year bund yield provided a better forecast of the T-Note yield in the years following (see Chart II).
German Yields with Maturities 3 months to 10 Years
The negative yield on the German 2-Year bund reached a low in September 2019, which was equal to the low in 2017. From our point of view, this low in negative German yields set the stage for a reversal in German yields, however, the German PMI has continued to decline to a new low of 41.4 in September. Any resolution to the China-US trade war, coupled with the decline in US yields and further drop in the federal funds rate (both of which stimulate growth in the US), would allow for a rebound in German exports and PMI, therefore allowing German yields to rise (see Chart III).
Spreads of US Treasury Yields to German Bund Yields
US treasuries to German yield spreads transitioned from positive spreads from 2013 to 2016, to inverted spreads in 2017 through year-end 2018. The sharp increases in spreads for the 2-Year and 5-Year yields above the 10-Year reflects an aggressive increase in the US federal funds rate in 2017 and 2018, accompanied by large negative 2 and 5-Year German Bund yields (see Charts III & IV).
Federal Funds Rate Raised Above the Level of Inflation
Historically the low in the federal funds rate has coincided with the level of inflation. Inflation is measured by the Personal Consumption Expenditures (PCE) excluding Food and Energy price index. Following the major recession of 2008, however, the rate was held at or near zero to aid recovery. The increases in 2017 and 2018 raised the rate to 2.5%, well above the 1.7% rate of inflation at year-end 2018 (see Chart V).
Reduction in the Federal Funds Rate
An increase in the federal funds rate from zero in 2014 to 1.25% in 2017 was an attempt to match the rate of inflation. However, the continued increases in 2018 to 2.5% caused inverted US to German yield spreads, with short term-term spreads rising dramatically over longer spreads (see Chart IV). This was an indication the rate increases were not sustainable.
In fairness to the Federal Reserve, in 2018 the US Manufacturing PMI rose to 60 and the inflation rate approached 2%, justifying the increases in the federal funds rate. They adjusted rates downward given the significant drop in US manufacturing PMI and a slowing economy. The Federal Reserve, however, was slow to react to the significant decline in US PMI and declining US treasury yields in early 2019, delaying reductions in the rate to 2.25% in July and 2.0% in September 2019. Another reduction to 1.75% is expected in December, followed by possibly two more reductions in 2020 to 1.5% and 1.25% (see Chart VI).
Trump Administration Indirectly Reduced US Treasury Yields and the Fed Funds Rate in 2019
The decline in the German Manufacturing PMI caused the German Central Bank to reduce bund yields. By September 2018, yields fell to a negative 93 basis points on the 2-Year and negative 73 basis points on the 10-Year. The strong relationship between yields of German bunds and US treasuries resulted in the US 2-Year T-Note peak yield of 2.9% in 2018, followed by the decline to a low of 1.4% in September 2019. Additionally, the US 10-Year T-Note peaked at 3.2% in 2018 and fell to 1.47% by September 2019.
The drop in German Manufacturing PMI was a direct result of tariffs placed on China by the Trump administration, as well as the threat of auto tariffs on Germany and other European countries. Therefore, indirectly, the actions of the administration led to the decline in yields on US treasuries and, consequently, reductions to the federal funds rate, which, in turn, has recycled consumption in the US economy.
Volatility in US Bond Yields
The sharp decline in the US 10-Year from over 3% in 2018 to 1.47% in early September 2018 was followed by a rebound to 1.9%, then a decline to 1.65%, and finally a recovery to 1.7%. Given the price of a US treasury is reciprocal of its yield, price volatility of all US treasuries remains extremely high.
Given normal yield spreads of US treasuries to German bunds of 1.7% and a recovery in German PMI allowing the German 10-Year yield to rise to positive 60 basis points, the US 10-Year T-Note yield is expected to increase 2.3% in 2020. Near-term, however, continued weakness in German PMI could result in a retest of the low in German 10-Year yields of a negative 73 basis points with a 2.2% spread, which would forecast a US 10-Year T-Note yield of 1.47% in October.
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