Introduction

The German 10-year Bund has emerged as a focal point for global investors recalibrating portfolios amid shifting macroeconomic conditions. As uncertainties mount around United States monetary and fiscal policy, European economic resilience, and geopolitical instability, Bunds provide a compelling alternative to US Treasuries. The recent sharp compression in the yield differential between the US 10-year Treasury and the Bund reflects this shift, driven by an evolving narrative that favours European fixed income assets over US counterparts.

Germany’s €500 billion fiscal expansion, coupled with market dislocations stemming from US trade policies, is prompting a revaluation of European assets. With a stronger commitment to domestic investment, fiscal relaxation, and a changing global monetary landscape, Bunds are increasingly viewed as a stabilising force within investment portfolios. However, uncertainties remain surrounding the execution and timeline of German fiscal policy, the timing and magnitude of European Central Bank (ECB) rate adjustments, and the trajectory of US economic conditions amid heightened political risk.

US Market Uncertainty and the Erosion of Exceptionalism

The macroeconomic trajectory of the United States has undergone a meaningful revision in recent months, as concerns over persistent inflation, slowing growth, and heightened geopolitical risk have led to downward adjustments in economic forecasts. The IMF has lowered its 2025 US GDP projection from 2.7% to 2.0%, with additional downside risks looming as consumer spending softens. Inflation data has been more benign than anticipated, with the latest core and headline CPI readings coming in at 0.2% versus the expected 0.3%, reinforcing expectations that price pressures may continue to ease. However, this disinflationary trend has been accompanied by increased market volatility, as evidenced by the sharp surge in the VIX, which has risen more than 80% since Trump’s inauguration.

The latest developments in US trade policy have further exacerbated uncertainty. The prospect of aggressive tariffs on Canadian, European and Chinese goods has stoked fears of supply chain disruptions and stagflationary pressures. If implemented, these policies could further slow US growth while simultaneously putting upward pressure on consumer prices, complicating the Federal Reserve’s ability to deliver accommodative policy. Market participants have started pricing in a potential policy mistake, with risk assets exhibiting heightened sensitivity to shifting trade rhetoric.

German Fiscal Expansion: A Paradigm Shift in Policy

Germany’s fiscal stance is undergoing a historic transformation, with Chancellor-in-waiting Friedrich Merz securing approval for a €500 billion spending package aimed at revitalising economic growth through infrastructure, defence, and climate-related investments. This policy marks a decisive break from the country’s long-standing commitment to fiscal conservatism, reflecting a broader recognition that structural investment is required to sustain long-term competitiveness. The implications for the Bund market are profound, as the anticipated increase in sovereign debt issuance will alter the supply-demand dynamics for German government bonds.

Despite concerns about debt expansion, market confidence in Germany’s fiscal management remains strong, as evidenced by the robust absorption of new Bund issuances. The latest auction results for the 10-year Bund saw a yield of 2.93%, a significant increase from the 2.5% level observed prior to the fiscal announcement, underscoring investor expectations for improved growth dynamics. However, execution risks remain, particularly regarding the timeliness and efficacy of fiscal disbursements. Market participants will closely monitor rolling economic data, including industrial production and PPI readings, to assess whether fiscal measures translate into real economic momentum.

ECB Policy and the Future of European Rates

The European Central Bank remains at the forefront of investor focus, with policymakers navigating a highly uncertain inflationary landscape. In her latest speech at the ECB and Its Watchers conference, Christine Lagarde emphasised the challenges posed by trade fragmentation, increased defence spending, and the potential for inflation shocks to become more persistent.

Lagarde’s remarks signal a cautious but flexible approach to monetary policy, reinforcing the view that the ECB will remain data-dependent rather than pre-committing to a specific rate path. Current market pricing suggests that the ECB will cut rates to 2% by the end of the year before gradually raising them to 2.5% by 2027. This trajectory is supportive of Bunds, as a more measured pace of rate normalisation reduces the risk of aggressive tightening. Furthermore, relative to the Federal Reserve, which remains constrained by domestic inflationary pressures, the ECB’s stance appears more accommodative, bolstering the relative appeal of European fixed income.

USD/EUR Dynamics and Capital Flows into Europe

The EUR/USD exchange rate has been a key barometer of shifting investment sentiment, with the euro appreciating to 1.0904 against the dollar amid renewed confidence in European assets. The tightening of the UST-Bund spread has played a significant role in driving this currency movement, as global investors reposition portfolios in favour of European debt. The strengthening of the euro further enhances the attractiveness of Bunds by mitigating imported inflation, which could allow the ECB to maintain a more accommodative policy stance for longer.

Capital flow data corroborates this shift, with fund managers reallocating exposure away from US equities and into European markets. ETF inflows into European bonds have accelerated, while sovereign wealth funds and pension managers continue to increase their allocations to German fixed income. The growing divergence in valuation between US and European equities has also reinforced this trend, as European small- and mid-cap stocks exhibit superior earnings growth at significantly lower multiples compared to their US counterparts.

The valuation disparity between US and European equities has become increasingly pronounced, challenging the long-held dominance of American markets. Historically, European stocks have traded at a discount relative to US equities, but the current valuation gap is among the widest seen since the 1980s, apart from the market trough in October last year.

This discount might be justified if US corporations were demonstrating significantly stronger earnings growth. However, a closer examination of the MSCI indices across various market capitalisation levels suggests otherwise. European small and mid-cap stocks not only trade at lower price-to-earnings multiples but also exhibit higher expected earnings per share growth, presenting a compelling relative value trade.

The MSCI Europe Small Cap Index is priced at 12.8 times forward earnings for 2024, with an expected earnings per share growth rate of 18.5 percent, yielding a price-to-earnings growth (PEG) ratio of 0.7. By contrast, its US equivalent trades at 19.4 times forward earnings, with an EPS growth expectation of just 9.3 percent, producing a much higher PEG ratio of 2.1. A similar dynamic is evident in mid-caps, where MSCI Europe Mid Cap trades at a forward PE of 13.9 with an EPS growth forecast of 9.1 percent (PEG: 1.5), whereas MSCI US Mid Cap commands a 2024 PE of 18.4, with lower EPS growth of 6.5 percent (PEG: 2.8).

The only US market segment where the valuation-growth relationship appears more favourable is in large caps, primarily driven by the outperformance of mega-cap technology firms. The MSCI US Large Cap Index trades at a 22.6x forward PE compared to 14.4x for its European counterpart. However, the expected earnings growth for US large caps is 11.2 percent, whereas European large caps are currently facing negative growth expectations, reinforcing the divergence at the top end of the market.

Bunds as a Hedge Against Equity Market Volatility

The growing uncertainty surrounding US fiscal and monetary policy, compounded by a weakening consumer backdrop and renewed trade concerns under the Trump administration, has led investors to reconsider the relative attractiveness of European assets. Nowhere is this more evident than in the German 10-year Bund, which has emerged as a favoured destination for investors seeking stability, liquidity, and quality amid market turbulence. The recent narrowing of the US-German yield spread is a clear signal of this shift, as funds flow towards German government securities in anticipation of more favourable risk-adjusted returns.

While US large caps have remained resilient, mid- and small-cap segments have struggled due to rising borrowing costs and increased policy uncertainty. Meanwhile, the German DAX and broader European indices have outperformed, supported by the fiscal tailwinds of Germany’s spending package. The VIX’s sustained elevation, driven by ongoing trade concerns and geopolitical instability, has made risk hedging a priority for institutional investors. Bunds have historically served as an effective volatility hedge, and with German yields now offering a more compelling risk-adjusted return relative to US Treasuries, the demand for Bunds as a safe-haven asset is expected to persist.

Conclusion: The Strategic Case for the German 10-Year Bund

The confluence of macroeconomic, fiscal, and monetary factors makes the German 10-year Bund one of the most attractive assets in the current investment landscape. The shift away from US exceptionalism, coupled with Germany’s unprecedented fiscal expansion and the ECB’s cautious policy stance, has created a favourable environment for Bunds to serve as both a source of stability and a yield-enhancing allocation.

The narrowing of the UST-Bund spread underscores the growing preference for European fixed income, while rising volatility in US equity markets further reinforces the case for Bunds as a diversification tool. With fund flows moving decisively into European assets and the euro strengthening against the dollar, Bunds are poised to remain a high-conviction trade in the months ahead.

At Regal Capital, we continue to position itself at the forefront of these macroeconomic developments, closely monitoring policy guidance, economic data releases, and market signals to inform our strategic allocation decisions. In times of market turbulence, the quality and liquidity of Bunds provide an essential anchor for diversified portfolios, ensuring resilience amid an evolving global investment landscape.

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