Good morning everyone. Today, through a scenario analysis and the creation of a bond sentiment index, we will try to determine which between US or European bonds represent the best choice.
1. TECHNICAL ANALYSIS OF IBGM AND IEF
The ETFs at the center of our analysis are the iShares € Govt Bond 7-10 yr (IBGM) and the iShares 7-10 Year Treasury Bond (IEF). The IBGM, as illustrated in the following chart, reflects the price movement of government bonds from the five main European countries by GDP (Germany, France, Italy, Spain, and the Netherlands) with maturities between 7 and 10 years and a duration of 7.79 years.
Ishares € Govt Bond 7-10yr. Weekly chart
Holdings. Source: iShares.com
The IEF, presented in the following figure, replicates the price changes of US treasury bonds with maturities between 7 and 10 years and a duration of 7.32 years.
Ishares 7-10 Year Treasury Bond. Weekly chart
Let’s start the technical analysis of the two ETFs, starting with IBGM. Since May 11, 2023, the ETF has not recorded significant price changes. However, it is interesting to observe the formation of two contrasting technical figures: a descending triangle followed by an ascending triangle, both with breakout. The ETF has shown an uptrend since the beginning of the fourth quarter.
Technical analysis IBGM. Daily Chart
As for the IEF, the situation is different. This ETF has shown a more bearish trend compared to the IBGM: from May 4, 2023, to the minimum of October 19, at $88.86, it recorded a negative performance of -11.84%. In the last sessions, the price has made a bullish impulse, catalyzed by Powell’s statements (interpreted positively by the market) and a weakening of the US labor market (unemployment rate rose to 3.9% from the previous 3.8% and non-agricultural payrolls at 150K compared to the previous 297K).
Technical analysis IEF. Daily Chart
To determine which of the two ETFs is stronger, it is necessary to create a strength index between the two and observe the trend. We obtain the index by dividing the price of the IEF by that of the IBGM, as shown in the following chart. The trend of the IBGM/IEF index is strongly bullish since the end of April 2023, indicating greater strength of the IBGM (dividend) compared to the IEF (divisor).
The IBGM/IEF strenght index. Daily chart
This means that the European government bond market has been stronger than the US one since April 2023. But why?
2. MONETARY POLICY AND INTEREST RATES
The outperformance of European bonds compared to US ones is linked to the monetary policy expectations of the ECB and the FED. Starting from July, the market began to price a more restrictive FED compared to the ECB, as shown by the two following charts. It is known that the 2-year maturities of the yield curve are the ones most influenced by monetary policy expectations. As can be seen in the following chart, the 2-year yield of the US government bond shows an upward trend (despite the bearish breakout of the dynamic trendline after Powell’s statements), while the 2-year yield of the German bond is falling.
Differences in monetary policy expectations. Daily chart
This suggests that the more the US 2-year yield outperforms the German one at the same maturity, the more the market prices a more restrictive monetary policy in the US. In the following chart, we build a spread between the two yields (with US02Y as minuend and DE02Y as subtrahend) to highlight the differences between the monetary policy expectations of the two central banks. By correlating this spread with the previously created IBGM/IEF index, we can confirm what has been said: the IBGM appears stronger than the IEF because it is expected that European monetary policy will be more expansive compared to the US one.
The positive correlation between IBGM/IEF and US02Y-DE02Y. Daily chart
"The US02Y-DE02Y index proves to be an excellent sentiment indicator to monitor in the near future, given its function as a ‘leading indicator’ on monetary policy expectations. But what does the future hold for us?3
3. US AND EUROPEAN BONDS IN THE NEAR FUTURE
Which bonds should we focus on in the near future? Would it be better to focus on US or European government bonds? Let’s start from a premise: the price of bonds tends to increase when interest rates are cut. So, the key questions to ask are:
‘Which of the two central banks will cut interest rates first? Which of the two has more incentives to keep rates higher for a longer period?’
The answer is simple: it will depend on the current and future macroeconomic conditions of the two countries. Considering the current data, the United States has shown a quarterly GDP growth higher than that of Europe for the first, second and third quarter of the current year, as illustrated in the following chart:
United States and European gross domestic product. 3-Month chart
The American economy seems to show greater resilience. This is also highlighted in the following chart, which calculates the strength index between the manufacturing and service PMIs of the two countries. The two US PMIs have outperformed the European ones since the beginning of the year, indicating greater resilience of the sectors.
The manufacturing and service sectors in the United States are more resilient than those in Europe. Monthly chart
In the following figure, we consider retail sales data, which are an excellent indicator of the level of consumer spending in both the United States and Europe (considering also that consumption represents a significant part of the gross domestic product.
Retail sales data. Source: Trading Economics
The situation is positive for the United States, but much less promising for Europe. In the latter case, one could even argue that the data indicates a sort of “recession,” with two consecutive negative readings, and the last one, with a -1.2%, decidedly more negative than the previous one. We conclude with the analysis of industrial production data, as illustrated in the graph below. In the United States, we have noticed a trend of progressively lower readings compared to the previous year, with a single contraction recorded in June. Instead, as far as Europe is concerned, we have witnessed a drastic drop, with readings in contraction from March until the last available data.
Industrial production data. Source: Trading Economics
From the graphs in this paragraph, it is clear that Europe seems to be closer to a recession than the United States. As a result, at the moment, the FED has more incentives to keep rates higher for a longer period, while the ECB could be the first to cut interest rates (in fact, we must not forget that phase 1 of the economic cycle is characterized by expansive monetary policies). If this scenario were to occur, we could see an increase in purchases of European government bonds (particularly German ones, considered safe havens given Germany’s high AAA rating), greater than those of the United States. But will this be the case next year? It’s hard to predict. The macroeconomic picture is and will always be influenced by the trend of macroeconomic data. In this regard, I recommend keeping an eye on leading data, capable of anticipating future economic trends, including certainly the PMIs, without forgetting US02Y-DE02Y. To date, however, it seems that European bonds may have a higher competitive advantage. See you soon!
1. TECHNICAL ANALYSIS OF IBGM AND IEF
The ETFs at the center of our analysis are the iShares € Govt Bond 7-10 yr (IBGM) and the iShares 7-10 Year Treasury Bond (IEF). The IBGM, as illustrated in the following chart, reflects the price movement of government bonds from the five main European countries by GDP (Germany, France, Italy, Spain, and the Netherlands) with maturities between 7 and 10 years and a duration of 7.79 years.
The IEF, presented in the following figure, replicates the price changes of US treasury bonds with maturities between 7 and 10 years and a duration of 7.32 years.
Let’s start the technical analysis of the two ETFs, starting with IBGM. Since May 11, 2023, the ETF has not recorded significant price changes. However, it is interesting to observe the formation of two contrasting technical figures: a descending triangle followed by an ascending triangle, both with breakout. The ETF has shown an uptrend since the beginning of the fourth quarter.
As for the IEF, the situation is different. This ETF has shown a more bearish trend compared to the IBGM: from May 4, 2023, to the minimum of October 19, at $88.86, it recorded a negative performance of -11.84%. In the last sessions, the price has made a bullish impulse, catalyzed by Powell’s statements (interpreted positively by the market) and a weakening of the US labor market (unemployment rate rose to 3.9% from the previous 3.8% and non-agricultural payrolls at 150K compared to the previous 297K).
To determine which of the two ETFs is stronger, it is necessary to create a strength index between the two and observe the trend. We obtain the index by dividing the price of the IEF by that of the IBGM, as shown in the following chart. The trend of the IBGM/IEF index is strongly bullish since the end of April 2023, indicating greater strength of the IBGM (dividend) compared to the IEF (divisor).
This means that the European government bond market has been stronger than the US one since April 2023. But why?
2. MONETARY POLICY AND INTEREST RATES
The outperformance of European bonds compared to US ones is linked to the monetary policy expectations of the ECB and the FED. Starting from July, the market began to price a more restrictive FED compared to the ECB, as shown by the two following charts. It is known that the 2-year maturities of the yield curve are the ones most influenced by monetary policy expectations. As can be seen in the following chart, the 2-year yield of the US government bond shows an upward trend (despite the bearish breakout of the dynamic trendline after Powell’s statements), while the 2-year yield of the German bond is falling.
This suggests that the more the US 2-year yield outperforms the German one at the same maturity, the more the market prices a more restrictive monetary policy in the US. In the following chart, we build a spread between the two yields (with US02Y as minuend and DE02Y as subtrahend) to highlight the differences between the monetary policy expectations of the two central banks. By correlating this spread with the previously created IBGM/IEF index, we can confirm what has been said: the IBGM appears stronger than the IEF because it is expected that European monetary policy will be more expansive compared to the US one.
"The US02Y-DE02Y index proves to be an excellent sentiment indicator to monitor in the near future, given its function as a ‘leading indicator’ on monetary policy expectations. But what does the future hold for us?3
3. US AND EUROPEAN BONDS IN THE NEAR FUTURE
Which bonds should we focus on in the near future? Would it be better to focus on US or European government bonds? Let’s start from a premise: the price of bonds tends to increase when interest rates are cut. So, the key questions to ask are:
‘Which of the two central banks will cut interest rates first? Which of the two has more incentives to keep rates higher for a longer period?’
The answer is simple: it will depend on the current and future macroeconomic conditions of the two countries. Considering the current data, the United States has shown a quarterly GDP growth higher than that of Europe for the first, second and third quarter of the current year, as illustrated in the following chart:
The American economy seems to show greater resilience. This is also highlighted in the following chart, which calculates the strength index between the manufacturing and service PMIs of the two countries. The two US PMIs have outperformed the European ones since the beginning of the year, indicating greater resilience of the sectors.
In the following figure, we consider retail sales data, which are an excellent indicator of the level of consumer spending in both the United States and Europe (considering also that consumption represents a significant part of the gross domestic product.
The situation is positive for the United States, but much less promising for Europe. In the latter case, one could even argue that the data indicates a sort of “recession,” with two consecutive negative readings, and the last one, with a -1.2%, decidedly more negative than the previous one. We conclude with the analysis of industrial production data, as illustrated in the graph below. In the United States, we have noticed a trend of progressively lower readings compared to the previous year, with a single contraction recorded in June. Instead, as far as Europe is concerned, we have witnessed a drastic drop, with readings in contraction from March until the last available data.
From the graphs in this paragraph, it is clear that Europe seems to be closer to a recession than the United States. As a result, at the moment, the FED has more incentives to keep rates higher for a longer period, while the ECB could be the first to cut interest rates (in fact, we must not forget that phase 1 of the economic cycle is characterized by expansive monetary policies). If this scenario were to occur, we could see an increase in purchases of European government bonds (particularly German ones, considered safe havens given Germany’s high AAA rating), greater than those of the United States. But will this be the case next year? It’s hard to predict. The macroeconomic picture is and will always be influenced by the trend of macroeconomic data. In this regard, I recommend keeping an eye on leading data, capable of anticipating future economic trends, including certainly the PMIs, without forgetting US02Y-DE02Y. To date, however, it seems that European bonds may have a higher competitive advantage. See you soon!