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Eurozone: peak growth momentum => peak in bond yields?

6/10/2021

Historically, a very close correlation has been observed between cyclical peaks in German economic sentiment –which since the start of the euro more or less coincides with the peak in Eurozone economic sentiment- and the 10 year Bund yield. The latter tends to decline, once the peak in sentiment has been passed. Although other factors also play a role in the dynamics of long-term interest rates, the historical experience is important to keep in mind when assessing the outlook for bond yields.

TRANSCRIPT // Eurozone: peak growth momentum => peak in bond yields? : June 2021

THE CHART OF THE MONTH

FRANÇOIS DOUX

In our Chart of the Month this month, we’ll be discussing expectations of economic growth. William De Vijlder joins us, and has identified a correlation. We will compare bond yields to the economic confidence index.

FRANÇOIS DOUX

Hello William.

WILLIAM DE VIJLDER

Hello François.

FRANÇOIS DOUX

Tell us first a bit more about this famous economic confidence. What is it?

WILLIAM DE VIJLDER

It is one of my favourite indices. It is prepared by the European Commission. It shows the average of confidence in industry, services, the construction sector, retail and consumer confidence. It is an excellent indicator of the mood of all these economic actors at a moment in time. It exists for the European Union, the eurozone and all EU member states. So, this is what I have prepared. I have taken the index for Germany and compared it with the performance of Germany’s sovereign debt, the 10-year Bund. Now, since the creation of the euro, the confidence index for Germany has been extremely tightly correlated with the same index for the eurozone as a whole. The conclusions we can draw from the German chart also apply to the eurozone.

WILLIAM DE VIJLDER

The conclusion is that there is very close correlation between the behaviour of these two series, which makes sense. As economic confidence improves, with economic actors, households and businesses growing more confident, this is not lost on the bond markets. Investors thus anticipate economic improvement and yields rise.

FRANÇOIS DOUX

What happens to bond yields once confidence levels hit a peak? You have come up with a second chart, which is something of a new development for our show. We can see it on the screen now. It plots bond yields, with, at the centre, the point where, in general, confidence peaks. Have I got that right, William? Explain what we are looking at.

WILLIAM DE VIJLDER

I was struck when preparing the first chart by the degree to which the peak in economic confidence and in long-term yields coincide. This is why I prepared this second chart. I first identified the peaks in economic sentiment, which are set to the zero point of the graph. I then looked at the level of long-term rates at the time this peak was reached, and how rates had moved in the previous four months. On the left of the chart, we have the four months leading up to the peak in economic confidence. So, where there is a rising series, where the line rises, rates have tended to rise as we approach the peak in economic confidence.

WILLIAM DE VIJLDER

We can also see what happens after the peak, on the right-hand side of the chart. What this shows us, that is really very interesting, is that in the majority of cases, once we are past the peak in economic confidence, bond yields tend to fall. This is an important observation for the present moment. Why? Because economic confidence has increased very rapidly in recent months, for understandable reasons.

WILLIAM DE VIJLDER

We can say that in all likelihood, we will hit the peak in this series within a few months. The peak in economic confidence. So, history tells us, that at that moment we will also hit a certain peak in bond yields. This is not to say that rates will not continue to climb after this point. But if they do, it will be for reasons beyond a simple improvement in the economic outlook. One factor, for example, could be trends in inflation. Another would be the influence of expectations of continued rate rises coming from the USA.

FRANÇOIS DOUX

So, we will need to keep a close eye on bond yields, particularly in the eurozone. Thank you William De Vijlder for this update on growth, confidence and the bond markets. Coming up, we will be talking about the Indian economy with Johanna Melka.

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