Bund yields: When will the downward spiral break?

The ECB expanded its asset-purchase program from 60bn to 80bn in March. Scarcity of bonds induced by the ECB stepped-up purchase program is one of the most interesting market drivers at the moment, despite Draghi’s bold statement that “we don’t see a risk of scarcity”.

Rates reached a new all-time low of less than 1 basis point on the 10th of June, despite a better economic outlook and rising commodity prices.

There is a self-reinforcing downward spiral in bund yields. The recent rally has resulted in more negative yielding German bonds, and reduced the pool of PSPP eligible bunds. At the moment, 58% of the universe is ineligible for purchase. This forces the Bundesbank to move further out on the yield curve, and leads to a further flattening of the curve. If the rules of the game are not changed by the ECB, we expect to see even capacity constraints before March 2017 in German bunds.

The risk is high that scarcity worries will continue support the bund, especially against the backdrop of a Brexit risk leading up the referendum. Polls in the UK indicate a tight race ahead of the 23 June UK referendum on EU membership.

The ECB’s latest reporting on the asset purchase program confirms the ongoing scarcity problem in most core countries in May, most notably in bunds. During May, the weighted average maturity of bund purchases rose to 9.2, the highest level since the start of the program. This is also seen in the spread of the 30 year bund yield against swaps. They are at their widest levels since March 2015 and the curve between 10 year and 30 year maturities in bunds flattened a lot.

We wonder what catalyst will break in the downward spiral, and can cause a potential sell off in the bund. The CSPP purchases have started, but there is doubt that the volumes of these will bring relief to the PSPP universe.  Supply has been responding to the pick-up in QE, and the prospect of the CSPP especially. Monthly corporate issuance has picked up to historic highs, and government bond supply showed a strong increase in duration, especially in the peripheral countries.

As such, the asset purchase program seems to be a mixed blessing, providing long term and cheap financing to European governments and companies. But at the same time it seems that these low financing rates encourage policy makers to postpone the structural reforms that are needed within the Eurozone. Mario Draghi has recognized this problem, which explains why he has stepped up his vocal warnings about the need for further reforms in recent weeks.

Kim Lubbers, portfolio manager at Kempen Capital Management

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