US growth fears highlight strength of European yields

Volatility in Bunds seems to have calmed down slightly in the last few days as markets continue to digest huge fiscal expansion plans from Germany and the European Union. At the same time, many forecasters have been downgrading their US growth projections after reassessing the level of pain President Trump seems willing to inflict on the US economy in order to implement his policy agenda.

The S&P 500 US equity index is now officially in correction territory as a result, having fallen over 10% from its recent highs. In fixed income, the shift in sentiment has triggered some credit spread widening and significant moves in all-in yields (see Exhibit 1).

What has driven these moves, and how do they impact our view on relative value?

Starting with the euro market, the main driver has certainly been the tectonic shift in Germany’s fiscal stance. Bunds sold off with spreads absorbing part of the move in certain sectors initially. After the dust settled and the most important driver became tariffs, spreads have widened while Bunds seem to be finding a new equilibrium at higher yields. Compared to their lows of a couple of weeks ago, euro spread moves have been smaller than those in dollars, but all-in yield moves have been large. That makes sense to us, given news of Germany’s fiscal bazooka is positive for growth and lowers the risk of defaults, all else being equal. More issuance and higher potential growth aren't good for government bonds, so higher Bund yields are also not surprising, but given Germany's comfortable fiscal situation there should be a ceiling for Bund yields.

Sterling markets have followed a similar path to euro assets but with less dramatic moves. Ten-year Gilts have sold off by 20bp compared to 50bp for 10-year Bunds, while spreads have widened but again less than their dollar equivalents. Growth projections for the UK have not changed and remain in the region of 1% for 2025, with some downside risk as markets and taxpayers alike nervously await the government’s latest spending plans on March 26.

In the US, the picture has shifted markedly. Markets have been swiftly reassessing the once consensus view that President Trump would be sensitive to falling stock market valuations in response to his administration’s economic programme. Tariff plans have been changing daily, which makes it difficult to make projections or plan ahead for many businesses. This has damaged growth forecasts as business confidence has taken a hit and some form of tariff increase has become the base case. US Treasuries (USTs) have outperformed European government bonds as a result, while US spreads have underperformed Europe. Since the Germany news on March 5, 10-year USTs have sold off by 10bp, though that is on the back of a 60bp rally since mid-January.

Where do these moves leave us regarding relative value?

In terms of the macro outlook, Eurozone potential growth might be higher than previously expected, while growth expectations for the US are being revised markedly lower, at least over the next couple of quarters. While we think it is too early to call the end of this episode of volatility since tariff headlines will keep coming, as medium-term investors we are always mindful that starting yield is historically a key driver of total return for fixed income portfolios.

To draw meaningful conclusions, we have go a step further than the table above. We have to compare indices across currencies that have a similar duration, similar rating and considering the FX hedging impact on yields. Euro yields now offer a significant premium over dollar denominated ones after adjusting for these. As an example, the euro 7-10yr corporate non-financial index has a yield in euros of 3.8% for an average rating of A-. Hedging this into dollars delivers an adjusted yield of 5.71%. The equivalent index in dollars has a yield of 5.28% for an average rating of BBB+. That is a substantial difference. Looking at the sterling equivalent, the yield hedged back to dollars is 5.55%, again with a better average rating of A-. These numbers show the euro and sterling markets currently offer more yield for less credit risk.

Our macro view does not include a US recession, but it is clear to us that growth will be lower than previously expected. Therefore, we would need to see further underperformance in US spreads to become bullish on that market. At the same time we don’t see UST yields rallying to recessionary levels, though we do think they could move somewhat lower from here. With 10-year Bund yields exhibiting some stability in the 2.9% area and better growth prospects due to fiscal stimulus, we think euro credit is set to outperform, in particular those sectors that look cheap on a relative value basis such as CLOs and financials.

Though we have seen more volatility than we expected so far this year, we continue to believe that with a medium-term view, carry will be the main engine of returns in 2025. European and UK assets look an attractive proposition after recent moves.