TNote-Bund correlation: new regime – Natixis

Maryline Perrinet, Research Analyst at Natixis, notes that currently, correlation between TNote and Bund sits at 54%, which corresponds to the levels observed in 2011, this when the correlation between sovereign rates in the US and Europe had been camping above 80% on average. 

Key Quotes

“Why this brutal change of regime? 

The strong correlation observed in 2016 can be explained by investment flow metrics: investors engaged in arbitraging between risk-free assets on both sides of the Atlantic during a period of negative interest rates in the Eurozone. Also there was the fact that quantitative easing (QE) drove domestic investors in the Eurozone to buy foreign bonds, which lessened QE’s impact on Eurozone interest rates. At the same time, the Federal Reserve proved sensitive to the international environment, notably uncertainties arising from the EU referendum in the UK. As a result, the divergence in monetary policies was not the factor of de-correlation it should have been in 2016. 

By contrast, the new regime takes on board both the lags in the cycles and the expectations regarding the future trajectory of monetary policy at the respective central banks (even though the prospect of a tapering by the ECB is very much on the cards at the start of 2018).” 

“Since Donald Trump’s election, the rise in interest rates is the telltale sign of the new playing field in the bond markets.”

“The reasons lie in the domestic political component and a context that is more favourable to inflation, which is being fuelled by the upturn in commodity prices, notably for crude oil. What can be observed is that the political component is not of the same order depending on whether it is external or domestic. In the US, the upturn in inflation and the fiscal stimulus package proposed by Donald Trump (coming when there is full employment) would lead to inflationary pressures on wages and to the appreciation of the US dollar. Reacting to these expectations, the markets have pushed up US interest rates since Donald Trump’s election. This factor has had a greater impact on US Treasuries than the political risks in Europe.”

“These factors are behind this discontinuity, ushering in a new regime, which could be described as more conventional in that measures and announcements by central banks once again play a decisive role.”

“Correlation being weak by past standards, the prospect is that it will recover to normative levels, which in turn is favourable to there being greater stability in the TNote-Bund spread in Q1 2017.”