The bond market in Europe looks increasingly vulnerable to more volatility. At the epicentre of souring sentiment are Bunds. This, not Greece, is dictating the direction of bond yields elsewhere in Eurozone bond markets
The macro backdrop for fixed income has turned decisively more bearish with solid jobs data from the US suggesting a rate hike as early as September even while the prolonged standoff between Greece and its international lenders is keeping the ‘Grexit’ theme alive. But these drivers are unlikely to be the main triggers for the souring sentiment in what is arguably the safest safe haven: German Bunds.
Bunds priced as though Eurozone remains in crisis-mode
Draghi’s comment must have been a wakeup call for investor when at the peak of their valuations in April, German government yields hovered just barely above zero percent for the 10-year Bund. The opportunity of the German government to issue Federal notes with 5 year maturity with a zero percent coupon since the start of the year shows how lopsided the credit market in Europe has become in favor of debtors and at the expense of creditors. Following the marked sell-off last month, the 10 year yield on Bunds climbed steeply to 1% even as its implied volatility hit 9%, levels not seen since mid-2011 (see Chart 1).
A better indication of potential significant mispricing in German debt is in its long dated inflation-linked securities (ILS) and the crisis-like yields these offer investors. Because with German’s 10-year real yields hitting a negative 1.38%, an investment in ILS only makes sense if investors forecast a decade of depression-like economic conditions for the Eurozone. Until last year this was justifiably the biggest concern. But after a series of exceptionally stimulus policies resulted in sub-zero policy rates, TLTROs and QE we are in all likelihood well past that point. And yet even after the violent correction, the fear premium paid for Bunds by investors has not entirely gone away. The real yield on German 10 year ILS continues to hover in negative territory which, at -50 bps, fundamentally suggests a decade of economic contraction.
While the ECB QE program is distorting the fundamental picture in secondary markets, there is visible evidence of more pronounced souring investor sentiment in primary markets, in particular for the very long dated Bunds. On its most recent issue of 30-year maturities by the German government on 28 January this year, it allotted only EUR 939 million after receiving bids of EUR 1.2 billion, the lowest on record and underscoring the fact that the Bunds’ 30-year issues average bid-to-cover ratios of since 2014 have markedly undershot the long-run historic average of 1.5.
Banks re-leveraging balance sheets marks an end to years of risk-aversion and signals confidence and strength
The nominal low and negative real long term yields of German bunds become hard to justify when there is growing evidence that the Eurozone has moved passed its crisis point. Eurozone’s banking sector has successfully restructured and undergone equity recapitalisations, particularly in Italy and Spain. More still needs to done, in particular with respect to the consolidation in Italy’s overbanked industry and the restructuring of delinquent loans in Spain. But overall, the bad banks created have made Eurozone banks’ balance sheets transparent. In fact, Evidence of Eurozone banks gaining strength is the expansion of loan books. For instance, since 2014, the deleveraging of bank balance sheets reversed, with private sector loans growing by EUR 95bn (to April 2015), an indication that banks see extending new business loans offering increasingly better risk adjusted returns as a viable alternative to hoarding government debt.
Efficient bearish positioning in fixed income with geared short ETPS
Greece is unlikely to have anything much to do with the recent sell-off in Bunds. Shut out from ECB QE support, the yields of Greek government debt have hit default levels well before QE was implemented and its steady climb since has not reverberated on Portuguese, Spanish or Italian government bonds. Instead, these have moved in lockstep with German Bunds and since the turbulence in bond markets started in May have also become more sensitive. For instance, the 10 year spread of Italian BTPs over German Bunds has risen from 90 bps in the end of March to 140 bps today.
There remains a real case for bearishness in Europe’s bond markets even after the recent correction. A potential opportunity presents itself for investors to short government debt in Europe.
Viktor Nossek – Director of Research – WisdomTree Europe