European savers applauded when the yield on long-dated German government bonds pushed back above zero as the seeds of recovery enabled investors to imagine the eventual end to the European Central Bank’s quantitative easing.
But Carl Weinberg, chief economist at High Frequency Economics, said investors could see a return to zero for the benchmark German 10-year yield. He says the country’s government debt will rally due to several factors: a dip in inflation, the new government’s continuation of fiscal discipline, and the ECB’s decision to push back rate increases into the second half of next year. Bond prices rise when yields fall.
The yield for the 10-year German government bond
or bund, has fallen to 0.328% from a three-year high of 0.762% hit back in February, according to Tradeweb data. The last time the German 10-year yield traded in negative territory was back in October 2016.
The supply of bunds to the market will decrease this year. Inflation will fall, not rise as the ECB suggests. That should push long-term bund yields toward zero,” Weinberg said in a Monday note.
That could strike U.S. investors as further proof that European capital markets are broken. Illustrious money managers like Bill Gross of Janus Henderson and Jeffrey Gundlach of DoubleLine Capital have, at one time or another, wagered for German bond yields to climb from their muted levels.
Bund bears have argued that inflation has persisted above its 10-year debt yield, meaning inflation has erased the value of its interest payments to bondholders who should shun its debt.
The other justification for higher German yields among analysts was that the ECB would have to end its bond-buying operations and plan its rate increases, joining the Federal Reserve in tightening monetary policy and leaving the ultraloose measures employed after the financial crisis behind. Though the ECB did lay out a plan to taper its monthly bond purchases in the final quarter of the year and end them in December, the central bank said it wouldn’t discuss raising rates until the second half of next year. Moreover, the ECB had all but ran out of room to make more meaningful bund purchases, Weinberg wrote.
“The ECB’s taper does not affect bund yields directly: the ECB was already fully invested in bunds up to its constitutionally imposed limit,” said Weinberg, meaning that German bond investors wouldn’t miss out on a reduction of the central bank’s asset purchases.
With the Fed seen continuing on its rate-hiking path as the ECB prepares to stand pat for at least a year, the yield spread between the 10-year Treasury
and the 10-year bund widened to 255 basis points, or 2.55 percentage points, around its widest levels since the founding of the eurozone in 1999.
Other than ECB policy, softening German inflation has also weakened the impetus for higher bond yields. Consumer prices, stripping out for volatile food and energy values, rose at a 1.7% year-to-year pace in May, and is projected to slow.
Thanks to open borders, the tight labor market in Germany hasn’t translated into more generous pay checks for the average German worker, which has seen a more subdued 0.3% year-to-year increase in wages in May.
“Germany’s economy is not closed. Germany is open to immigration of unemployed workers from the parts of the EU where economic conditions are not so good,” said Weinberg.
The final ingredient for a bond market rally even at these expensive levels, he says, is the dwindling supply of debt as new finance minister Olaf Scholz, who took over in March, continues his predecessor Wolfgang Schäuble’s penchant for fiscal rectitude. Scholz’s proposed budget would see the government run a fiscal surplus between the 2019-2022 budget period.
The German Finance Ministry estimated it would issue 6 billion euros less of bonds than it had expected for the third quarter of 2018.