The cyclical relationship between the US and European economies

The cyclical relationship between the economies of Europe and the US is very well documented, and so is the link between them. We also know, sometimes intuitively, that one economy tend to “lag,” on the upside or the downside, the other. What may more surprising is how visually striking this relationship is when plotting term rates in one economy versus those in the other, or when plotting yield curve slopes against those in the other region.

The figure below plots Germany’s 2-year Euro swap rates, over the past 8 years, against the 2-year USD swap rates. The cyclical nature of the relationship is more than a metaphor: the plot is literally circular.

Source: Bloomberg. Data as of March 19, 2009, when this study was actually conducted. Click picture to enlarge.

Starting with the top right quadrant and going counter-clockwise, the 2001 time series (plotted in brown) moves down to the left. The time series moves deeper toward the bottom left corner in 2002, stays there in 2003, and initiates a move back “up” in the cycle. We can observe that the 2y swap rate increases significantly in the US but stay basically range-bound in Germany during the next two years, 04 and 05. The German rates rose in late ’05, ’06 and early ’07, completing the first iteration of the cycle. During ’07, we can clearly see that a second iteration started: the US 2-year rates started to decrease while the German rates stayed essentially flat before catching up with the US rates in ’08. As of now, we’re basically back to the point the cycle reached in early 2004. A back of the envelope estimate of the periodicity of the cycle is thus a bit over 5 years.

By the way, the 2-year rate is not the only one exhibiting this nice, visual cycle: you may want to try the 5-year and 10-year rates, and on periods preceding 2004 – the graphs are surprisingly similar, although they tend to be illegible if you consider too long a time frame. You can also try instruments other than swaps, such as on-the-run Treasuries.

The cyclicality of the two economies can also be observed by plotting yield curve slopes. The next figure plots the German 5y-10y swap rate slope, as measured by the rate spread, against the same slope on US rates.

Source: Bloomberg. Data as of March 19, 2009, when this study was actually conducted.

The cycle here goes clockwise: Starting in 2002 around the center of the graph, the German and US yield curves steepened in tandem until mid-2003. Their slopes stabilized around 100bp and 80bp, respectively, before flattening in 2004 and early 2005. By mid-2005, the US curve kept flattening but the German curve kept about the same slope, anticipating the cyclical movement of re-steepening of both curves in ’07. The curves steepened in the first half of 2008 back to the where they were in 2002, completing the cycle in about 6 years – which is consistent with our earlier estimate of 5-year periodicity. 2008 was a bit of an exceptional year as we all know, and the curve slopes went all over the place in H2’08; it is striking however to see we are now back on the cycle, basically where we were in late 2002.