Source: Bloomberg
Source: Bloomberg

Until 2012, US and German bond yields traded in line with each other. Then came Europe’s financial crisis and a great divergence.

There are several reasons why German yields fell so much faster than their US counterparts: 1) with the credit of the Club Med countries in doubt, German government bonds carried a premium as a safe harbor investment; 2) with the recovery from the US financial crisis, Treasury bonds carried less of a premium as a safe harbor investment; and 3) the European Central Bank in 2016 began buying government bonds aggressively and now owns nearly a third of the outstanding float of German government debt.

Europe’s recovery lagged the US–until last year, when it began to grow faster than the US. Europe’s periphery is not quite out of the mud, but risks have diminished.

German and US bond yields will converge over time. If they do, the prices of German bonds will fall roughly 16% relative to US Treasuries. The US-German “convergence trade” will be a hedge fund favorite for the next couple of years.