Indicator Series Vol. 7: Relative Interest Rates

Country GDP Rough % 10 Yr Yield Weighted Yield
Germany $3,754 37% 0.46% 0.002
France $2,489 25% 0.89% 0.002
Italy $1,852 18% 2.18% 0.004
Spain $1,252 12% 1.66% 0.002
Netherlands $770 8% 0.57% 0.000
Rough EuroZone 10 Yr Yield 1.04%
US Yield 2.35%

Using a rough estimate of Europe’s 10-yr interest rates, on a weighted basis, by GDP, we can compare similar, to some degree, economies. In terms of creditworthiness, most would argue that the US stands above the Euro area because it is the world’s reserve currency. Simply according to the yield differential, that does not seem to be the case. It is clear that, here in the US, we are further along in the business/interest rate cycle than across the pond, but should that still justify such a difference in yields on sovereigns?

In normal business cycles once a developed economy gets moving and inflation starts to pick up, a central bank will start to increase the cost of borrowing to slow down the expansion of credit, and this will effect business as a whole. This should bring capital into that economy due to the better yields on their bonds. Once investors bid up bonds to take advantage, the yield should start to fall, or at least stabilize. Of course, this is not a normal business cycle any way you look at it. Central banks around the globe have been buying fixed-income securities by the truck-load to keep yields depressed-and money easy.

Despite the fact that the European Central Bank is easing at a clip much more significant than the Fed, should the yield spread still be so wide? It seems as though two conflicting theories are at play while the Central banks are hard at work stabilizing the system.

While we are different nations, we do work, invest and do business in the same connected world. This means that disparities in the most fundamental price in the markets, the price of money via interest rates, can have widespread effects. As an example, if the US were to begin a less than tightening to money and our economy held strong, our interest rates would rise and our dollar should rise as well. As investors pour capital into our borders to take advantage of a better yield, the dollar would strengthen. A strengthening dollar would make imports cheaper than they once were.

One would think that this would not be especially great for the margins of exporting countries that do significant business with the US. To combat this, they may begin to tighten monetary policy as well, narrowing the relative yield differential. While this is all well and good in theory, it does not seem to be occurring today.

The difference, I think, lies in the place at which each country resides in the credit cycle. One year ago the US 10 Year Treasury was at 1.83%. That looks a lot closer to where the Euro Zone is today. Could it be that the Eurozone is about 1 year behind the US in it’s cycle?


The graph above shows the yield of the blended Eurozone and one of the US. It seems as though the Eurozone is a bit behind the US in the credit cycle, so while the Fed is now talking about normalization, across the pond the chatter is about another year plus of QE. This has worked out well for US investors sending funds overseas into equities because of the strengthening US dollar. (As you’ll know, US returns = Foreign Equity Performance X Foreign Exchange Performance)

As an indicator, how far along in the credit cycle, and how far along in extraordinary easing tend to be helpful. As some say, “Don’t fight the Fed”, I tend to think the same in terms of investment. Easy Money = Easy Money.


Source: ECB SDW