Reflecting on August: Flattening Government yield curves

A month of flattening government bond yield curves and a stronger Euro

Is the government bond market suggesting trouble ahead?

What has happened?

Core government bond yield curves bull flattened during August. This means that, as government bonds performed well, yields fell across the board but to a greater extent at the longer end of the curve than at the shorter end.

Why?

August was a month when a degree of risk aversion crept into the market. Geopolitical risks developed, with aggressive rhetoric and missile tests from North Korea, aiding the performance of core government debt. Furthermore, some economic data, particularly those on the UK economy, disappointed.

What should you take away from it?

One economic theory states that long-term government bond yields are determined by current and future expected short-term rates, and therefore the shape of the yield curve is dependent on market participants’ expectations of future interest rates. With that in mind, an upward sloping yield curve indicates that the market expects interest rates to rise over time, perhaps as the economy grows and inflation rises. Conversely, an inverted yield curve, where short-term yields are higher than long-term yields, has traditionally been an accurate predictor of recessions. Although UK, US and German government bond yield curves are upward sloping, the flattening that occurred in August, especially in the UK, is an indication that the market may have become less positive over future economic prospects.

The euro hits a three-year high

What has happened?

The euro, on a trade-weighted basis, reached its highest level since 2014 in August. It rose by 0.4% versus the US dollar and 2.8% versus the pound.

Why?

While the strength in the euro has come on the back of an improving economic outlook for the eurozone since the beginning of the year, it is also a product of weakness in other major currencies. Sterling continues to perform poorly with Brexit negotiations still the cause of considerable uncertainty, while President Donald Trump’s inability to implement his campaign promises has weighed on the US dollar.

What should you take away from it?

On a trade weighted basis, the euro is higher by 8.5% this year. Versus the US dollar it is up 13.0% year-to-date and versus sterling it is higher by 7.9% over the same period. The strong performance has led some market participants to suggest that the euro is overvalued. On a trade-weighted basis the euro is currently above its long-run average, however, should the euro area economy continue to perform well, there is scope for the euro to strengthen further, particularly versus sterling if Brexit negotiations go badly. That said, were economic data to deteriorate in the eurozone this could weigh on the currency. Additionally, while political risk has subsided in the euro area following the spring’s French elections, Germany is set to go to the polls in September and Italy will hold an election before May next year, with the latter in particular the potential cause of uncertainty.