Tuesday, January 6, 2015

Why Are Yields Lower On German Government Bonds Than US Bonds?

Paul Krugman explains why government bonds in the eurozone pay lower interest rates than US government bonds.  Investors believe that US and German bonds are risk free.  Therefore, something besides the risk of default is needed to explain why German bonds pay lower interest than US government bonds.  Investor expectations about inflation, and the relative values of the euro and the dollar, determine the yield difference.  Investors expect inflation to rise by 1.8% in the US over the next decade.  They anticipate that inflation in Germany and the eurozone will increase by about half of the rise in US inflation.  Therefore, about 60% of the interest differential between the US and Germany is due to inflation expectations.  Inflation expectations are higher in the US because the US economy is stronger.  Investors also expect that the dollar will decrease in value relative to the euro over the next decade.  That explains the rest of the difference between the interest rate on US and German government bonds.  They expect that the dollar, which has risen in value versus the euro in recent months, will fall back to where it was prior to the recent  increase in the value of the dollar.

The bottom line is that investor expectations about inflation and the relative value of currencies explain the difference in interest rates between German and US government bonds.  It also explains why the interest on government bonds in Spain and Italy are also lower than US interest rates.  There is only a small risk premium on Spanish and Italian bonds versus German bonds.

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