MBS Live Day Ahead: The Biggest Risk to Fledgling Bond Bounce

Today begins the 3rd day where US Treasuries aren't imploding after hitting 7 year highs last Thursday.  At this point, we might consider the resilience to be some sort of fledgling bounce attempt, even though we can continue to be concerned about technical floors (discussed here).  But let's say that 3.06% in convincingly broken today and confirmed tomorrow.  Then what?

If that happens, I will be looking squarely at the Italian political drama and European bond markets.  

What follows is a bit of an outline for a more robust primer on the topic of European bond markets as they interact with US bond markets.

Does rate volatility in Europe really affect US rates?

There can be no greater proof of this than the summer of 2012, when the EU debt crisis was at its apex.  There's no way we would have achieved those all-time lows without Europe.  Same story with Brexit in 2016, as it was the key driver of the next visit to all-time lows.  The world is interconnected. 

The health of the European economy affects the global economy.  That's one reason EU bonds matter elsewhere.  The health of the EU economy also affects its ability to conduct trade in the US, and trade relationships are key drivers of foreign demand for US bonds.  In other words, if European countries are selling fewer exports in the US, they don't need to buy as many US Treasuries.

What's up with these "German Bunds" I hear so much about?  What's all the fuss with Germany?

Germany is the de facto political and economic hub of Europe because it's the clear leader in terms of output.  France is generally a distant 2nd and Italy a more distant 3rd.  While EU countries are united in various political ways and while Eurozone countries share the Euro currency, the bond market is still divided country by country.  For that reason, the bonds of the largest and most economically stable country end up as the representative for the entire Eurozone.  In other words, German 10yr debt = EU 10yr debt.

Why does "stuff" that happens in other countries affect German debt?

As we just discussed, Germany is the biggest and most stable.  It's going to fare the best in any scenario that damages or dissolves the Eurozone.  We've seen this play out time and again with various peripheral countries going through turmoil.  The peripheral debt yields spike while Germany's fall.  This spread is indicative of financial stress in the peripheral country.  That's what's going on with Italy at the moment.

Bottom line for now: Italian drama has been the only reason that German 10yr yields have been able to hold their ground recently, and the only reason US yields haven't risen further.  The risk is that any sort of recovery of Italian sentiment will put immediate upward pressure on German/US rates.