The beginning of the Fed rate hike cycle is likely to restore the normal directionality of the Bund-UST spread. At current spread and FX levels, Bunds are unlikely to act as a strong anchor for USTs. However, the next episode of Bund-UST widening is likely to be led by breakevens and longer-dated forwards.
More than two years ago, the ECB launched its version of forward guidance, to insulate the euro area rates market from the effects of the US taper tantrum. Almost exactly a year ago, at Jackson Hole, Draghi pre-announced the beginning of the ECB's journey into QE, closing the policy gap between the ECB and most other major central banks, including the Fed.
Consequently, Bunds began driving USTs and the directionality of the Bund-Treasury spread inverted. A key question to address is therefore how the Bund-Treasury spread will evolve as the Fed starts hiking rates.
"We believe there are two key issues to address.(1) What will restore the historical directionality whereby the US leads global rates markets? (2) To what extent will Bunds anchor the UST market, even once the Fed starts hiking", says BofA Merrill Lynch.
The directionality between the USD and EUR rates markets , is a result of the different activism of the Fed and the ECB, respectively. To simplify: traditionally, the Fed is the more activist central bank, leading both in easing and tightening cycles and therefore driving the historical outperformance of USTs in a rally, and underperformance in sell-off. In 2013, this resulted in the widening of the Bund-Treasury spread during the taper tantrum.
"In 2014, the Fed was essentially sidelined with the taper priced in, and the marginal monetary policy impulse coming from the ECB's descent into QE, tracked through Draghi's speeches in Amsterdam (April), Sintra (May) and Jackson Hole (August). Consequently, the Bund market started leading the Treasury market and the Bund-UST spread widened in a rally. In other words, the Bund-Treasury spread was driven by the expected divergence of real policy rates", notes BofA Merrill Lynch.
