In May, a German sovereign bond (bund) selloff took markets by surprise, with 10 year bund yields rising from record near-zero lows since the beginning of ECB quantitative easing (QE) in March, to pre-QE highs. The sharp rise in bund yields is understood to have been exacerbated by a lack of liquidity and investor positioning, however it has also called into question the future of QE, and whether the 1.1 trillion EUR programme will be enacted in full. We take a look at some of the drivers behind the recent price action in bunds, whether it is the start of a new trend and question if the pricing action could signal prospective changes to the ECB QE programme or an end to ultra low rates in the Eurozone.
Firstly, it is worth noting that the sell-off was part of a global phenomenon, however the 10 year benchmark bund underperformed almost every other developed market, except France. The sell-off was predated by a 5 year German bund auction that failed to attract sufficient bids, which was likely a significant catalyst.
The bund selloff coincided with better than expected inflation data, as the German CPI printed +0.5%y/y in April and remained stable over the month. Broadly, Eurozone inflation in April also rose from a trough of -0.6%y/y in January to 0.0% in April as oil price deflation moderated. Eurozone real GDP also improved in the first quarter, expanding +1.0%y/y, in line with expectations, as the region starts to show gradual signs of a pickup in economic activity. Thus, the spike in bund yields may partially be due to an improving Eurozone outlook, suggesting that markets may doubt the ECB's commitment to implement the QE programme in full as inflation begins to show signs of acceleration, thereby potentially bringing forward the attainment of the ECB's goal for QE to stabilize inflation around the target of 2%y/y.
Rising bund yields also corresponded with a recovery in oil prices. As a net importer of oil, Germany (and the entire Eurozone) experienced very low inflation expectations and even the threat of deflation earlier this year, but the rise in oil prices clearly diminished this risk.
German Bund Yields Track Oil Prices
Although fundamentals clearly had an impact, the spike in bund yields has also been magnified by seasonal low liquidity in the cash market and by market positioning. For example, Eurex bond futures saw an increase in outstanding contracts, reaching levels not seen since the European crisis in 2011, becoming the favoured instrument to hedge long duration exposure, at the same time as a sharp decline in bund cash and futures markets' liquidity, which according to J P Morgan1, was lower than levels seen around the October “flash crash.” Moreover, since the beginning of the selloff, brokers argue that “trend-following positions” in German bunds have likely been liquidated and the sharp move is also impacting other Eurozone bond markets and other markets such as the FX market.
ECB communication following the selloff argued that it is not concerned with the bund price action itself, but with the speed and volatility of the moves. ECB board member Benoit Coeure argued that the bund price action “recreates two-way risk” and could reflect a reassessment of scepticism on the economic impact of QE. Coeure stated that the ECB interpreted the rapidity of the price move as symptomatic of low liquidity, and subsequently announced ECB intention to adjust the pace of QE purchases. For example, the ECB is expected to front load purchases in the summer months (May - June) to compensate for seasonal low liquidity over the summer and can back load purchases in the months following, if necessary. The pace of QE purchases is, therefore, now changeable, which is unique amongst major central bank QE programmes. For example the July 60BN EUR of purchases is likely problematic from a demand and supply perspective due to large bond redemptions and coupon repayments. Coeure also announced that official policy rates will not be cut further, however he stressed that the negative ECB deposit rate (-0.2%) complements QE by increasing the velocity of reserves and accelerates portfolio rebalancing efforts.
The recent announcement of adjusting QE purchases on a seasonal basis over the summer has fuelled some market speculation as to whether the ECB is in fact acting out of disappointment on the current impact of QE, given the sudden and rapid spike in bund yields to pre-QE highs. However, prior to the announcement to increase the QE purchases over the summer months, ECB President Draghi reiterated the institution's commitment to QE in full, regardless of price moves. He also noted that although the QE programme asset purchases will have a substantial effect on asset prices and economic confidence, the primary concern is that there is an equivalent effect on investment, consumption and inflation. With that intention, he reaffirmed that “we will implement in full our purchase program as announced and, in any case, until we see a sustained adjustment in the path of inflation.”
We do not expect the recent steepening of the bund yield curve to be the beginning of a sustained new trend. Firstly, 5yr5yr forward inflation data, a common measure used by central banks to consider a market's future inflation expectations, is still rising in the US and declining in the Eurozone, which supports a flatter bund curve.
US-German 5Yr5Yr Forward Breakeven Rate Differential (pp)
Moreover, Eurozone and German economic data, albeit improving, are not sufficient to support the higher bund yields on a sustained basis, as inflationary pressures remain subdued.
- Global Rates Strategy. May 13, 2015. “Market depth declined when it was mostly needed.” Authors: Fabio Bassi and Khagendra Gupta