When corporate spreads are narrowing relative to the risk-free rate, it suggests there is a view among market participants that the economic outlook is improving and, accordingly, that there is less risk of default. The converse also holds true, which is why the spread between corporates and Treasuries is watched closely as a sign of confidence -- or lack thereof -- in the economic outlook.
What about spreads, though, between government securities?
The U.S. market is currently battling concerns about a flattening yield curve, which isn't exactly what one would expect to see if there was strong faith in the economic outlook.
Generally speaking, the curve should be steepening with the 2-year - 10-year spread widening on a promising outlook as stronger growth should lead to a pickup in inflation, which would drive up rates at the inflation-sensitive back end of the curve. Lately, however, that hasn't been happening.
The Federal Reserve raised the target range for the fed funds rate in December and March to account for the improvement in economic activity, but strikingly, the yield on the benchmark 10-yr note has come down sharply in recent weeks, dropping at a faster pace than the yield on the 2-yr note has been dropping; hence, there has been a flattening of the yield curve with a narrowing in the 2-10 spread.
What this means is a great source of debate at the moment. It could reflect any number of things:
- Bond buyers aren't buying the idea that the U.S. economy is ready to accelerate sharply
- Bond buyers aren't expecting a big pickup in inflation
- Bond buyers are anticipating that the Treasury market will benefit from a correction in the equity market
- Foreign bond buyers are still embracing the interest-rate differential trade
- Bond buyers are sniffing out the prospect of a (geo)political event triggering a flight-to-safety
- It might reflect the generational shift of retiring baby boomers looking to secure guaranteed income
There could be more to it than the reasons noted above, yet the 2-10 spread relationship is one that will continue to be watched closely.
Unsowing Some OATS
In the same vein, the 10-yr spread between the French OAT and the German bund is also drawing some increased scrutiny these days, because it has widened considerably over the past six months or so.
The impetus for that move hasn't been so much for economic reasons as it has been for political reasons, yet the two are interconnected.
France will be holding its presidential election, starting with a first round of voting on April 23 to determine the final two candidates who will face a second, and final, round of voting on May 7.
The concern leading up to the election is that an anti-EU candidate will win the presidency. That specifically includes Marine Le Pen, leader of the far-right Front National Party, and Jean-Luc Melenchon, head of the far Left Party which is backed by France's Communist Party.
While news sources continue to suggest either candidate would lose in the second round of balloting, nothing is being taken for granted following the misleading polling data leading up to the Brexit vote and the U.S. presidential election.
Madame Le Pen and Monsieur Melenchon are both seen as having a viable chance of pulling an upset, with Madame Le Pen out front in the possible upset bid.
The widening spread between the French OAT and the German bund is a reflection of the growing angst in front of the election, as it is assumed a presidential win by either Madame Le Pen or Monsieur Melenchon could threaten the existence of the EU and throw the economic bloc into a maelstrom of economic uncertainty.
What It All Means
The German bund is effectively the benchmark instrument in the EU given the size and fiscal strength of the German economy, so it becomes the beneficiary of a flight-to-safety trade when uncertainty picks up in the eurozone.
This widening spread, then, is a hedge for the possibility of upheaval in the EU due to the French election, as investors are favoring the relative security of the German bund over the relative insecurity of the French OAT, which would be expected to come under some serious selling pressure if either of the anti-EU candidates prevailed in the presidential election.
Conversely, if both fail to win the presidency, the spread between the French OAT and German bund should narrow as the election uncertainty -- and some of the economic uncertainty by default -- is removed.
A widening in the spread after the avoidance of a worst-case scenario would be an entirely different matter, as it would suggest economic growth differentials between the two countries run deeper than the political headlines.
No need to get too far ahead of ourselves.
For now, the political situation is front and center in the spread relationship (but perhaps front and far left, if not front and far right, if you catch our political drift).
Time will tell more about political and economic feelings regarding the EU and so will the direction of the 10-yr spread between the French OAT and the German bund.