Germany's 10yr Bund about to join the negative yield club? Is it possible that we getting just a little TOO bearish?

2nd March 2016

Germany's 10yr Bund about to join the negative yield club? Is it possible that we getting just a little TOO bearish?

ref :- "Short View" by Katie Martin, The Financial Times

There's nothing new under the sun ..... or so some would have us believe. The market's reaction to disappointing Eurozone manufacturing data and renewed deflationary fears has been predictable enough, with tumbling bond yields (and therefore soaring prices) reflecting the growing assumption that the ECB will be forced to take further monetary easing measures, and quite aggressive ones, at its meeting next week. The yield on the benchmark German 10yr Bund has traded as low as .13% (as we write, 0.17%), and it's more than possible that Germany will soon see its 10yr government debt join that of Switzerland and now Japan in trading in negative territory.

We've been here before of course. At the start of 2015 10yr Bunds yielded over 0.50%, but against a background of poor data and more particularly of the ECB bond-buying programme (QE) that sparked genuine fears of whether there would be enough bonds to buy, yields fell to a low of 0.048% by mid-April. On that occasion however, as worries over a "bond shortage" abated and speculation of an imminent US rate hike grew, yields took off to nearly 1.00% June. It was a bloody couple of months for bond traders. So where do we go this time?

Even after all this time, discussing below-zero still takes some getting used to. Intuitively, negative yields on a ten year instrument still seem ..... well, a little bonkers. As Ms Martin says, what it means is that investors who in the past would have bought ultra-safe government bonds rather than risk losses on dicier investments are now queuing up to buy paper that, should they hold them to maturity, will guarantee them a loss. Bearing in mind what happened last year, are there really going to be the buyers to take these yields well below zero? The short answer to that is .... yes, probably.

We often say (particularly when we're struggling with the principle of negative yields) that just because a yield is negative doesn't mean it can't go more negative  .... and therefore prices rise. But what the ECB decides to do will be key to determining how low yields will go. It has ruled itself out of buying any bond that yields less than the deposit rate which stands at minus 0.3%. Currently, that means that about half of the top name European government bonds are off limits. But if the ECB should drop the discount rate to minus 0.5% say, there's plenty of room for bond prices to rally and yields to fall before 10yr bund yields reach that level.

The point Ms Martin is making is that 10yr bund yields probably will go below zero and could stay there for some time, but such a development does require the bond market to take a particularly pessimistic view on all kinds of levels. It would be building in a market view that Eurozone inflation will not reach even 1% in 5 years, which is quite an assumption given the unpredictability of oil prices over such a period  --  even stabilization would influence inflation higher. Negative yields out to 10 years and beyond would be reflecting nervousness over everything from a Chinese collapse, through a reversal in the path of US interest rates even to turmoil that Brexit might bring to markets.

All of these things may very well come to pass .... but then again they may not. We are constantly witnessing how sharply markets can change direction when everybody is positioned one way. It might not take much in the way of better news to prompt a sharp reversal, as traders caught the wrong side of last year's snap-back will testify.