A Tale of Two Economies

U.S. and European debt tell a tale of two increasingly different economies, days before the European Central Bank’s (ECB) next policy decision.

As shown in the LPL Chart of the Day, on Thursday, October 18, the 10-year U.S. Treasury yield closed 2.76% higher than the German 10-year bund yield, the widest spread since 1986. Yields on German debt, the Eurozone’s largest country, which serve as a proxy for economic expectations of the broader region, have floundered as yields on comparable U.S. debt have climbed to their highest level in seven years.

A Tale of Two Economies: U.S.-German 10-Year Yield Spread

The 10-year Treasury yield has closed higher than the 10-year bund yield every day since February 2012, and the distance between the two has climbed steadily since then. To us, this disparity illustrates investors’ increasing expectations for economic growth in the U.S., while European growth expectations have remained relatively stagnant.

“The growing spread between U.S. and German yields shows the stark divergence in global monetary policy and economic expectations,” said LPL Chief Investment Strategist John Lynch. “U.S. debt will likely remain the cleanest shirt in the laundry pile as the rest of the world’s economies lag behind.”

The recent surge in the 10-year Treasury yield has been powered by speculation around the future path of U.S. interest rates given solid economic data and accelerating (but manageable) inflation. In the Federal Reserve’s (Fed) latest meeting, policymakers discussed the possibility of raising rates beyond the longer term neutral rate and projected that interest rates will likely peak in 2020.

In contrast, Europe’s economy has been a laggard in the current expansion, plagued by fiscal and political issues in several countries and a continued need for structural reforms to help unleash economic potential. The ECB is expected to start reducing its bond purchases this month (likely announcing tapering at its upcoming meeting) and end its bond buying entirely by the end of the year.

Europe’s fiscal and political struggles will likely continue to weigh on its economy, which will keep overall yields in the region subdued relative to those in the U.S. This policy divergence has ramifications for every asset class, and may even influence the Fed’s future decisions on monetary policy (as it considers the stability of the global economy). We don’t see the gap closing any time soon, and now with higher yields, we think Treasuries remain attractive to global investors for diversification, liquidity, and income.

IMPORTANT DISCLOSURES

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.

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