Natixis fixed income strategist Defossez agrees with Schaeuble view on low Bund yields
René Defossez, fixed income strategist at Natixis, agrees with the analysis from German finance minister Wolfgang Schaeuble recently, that the unnaturally low yield for Bunds is not the financial godsend it first appeared to be.
The Bund yield is a measure of stress in the eurozone and when this yield sits at 1.50%, the stress level is very high. This makes the Bund yield a very poor measure of Germany’s credit risk – which is what the finance minister was hinting at.
The left-hand table below indicates the safe-haven role played by the Bund, reflected by the negative correlation between the yield for the Bund and for peripheral bonds since 1 May. The right-hand chart indicates the correlation between 5-year CDS for all eurozone sovereign bonds, which has been strong or very strong in all instances. In other words, Germany has very significant exposure to the many facets of eurozone risk.
The Bund’s CDS premium stands at 135bp, more than that of Chile and way more than that of non-European Monetary Union triple-A sovereign bonds (92bp for the UK, 79bp for Sweden, etc). Apart from Finland (98bp), CDS premiums for other Eurozone triple-A sovereign bonds are equal to or more than the Bund’s CDS premium. There is therefore a specific risk, measured by the CDS, linked to exposure to eurozone risk.
However, Germany’s fundamentals are not exceptional – most notably its debt exceeds 80% of GDP and its economy is slowing. Indeed, manufacturing PMI has been less than 50 for quite some time, the ZEW and IFO indices are on a downtrend and the labour market is deteriorating. This is no great surprise given that Germany has significant exposure at trade level to the eurozone, which is in recession.
Some small credit rating agencies, like Egan-Jones, have already downgraded Germany’s credit rating. Even leading rating agencies have downgraded several German banks, citing their exposure to the eurozone.
Potentially, Germany’s financial exposure to euro zone risk is colossal. If all conceivable financial hazards came about, Germany could end up incurring losses of more than €600bn through its participation in the bailouts and its share of the peripheral bonds held by the European Central Bank (ECB) and Target 2, the real-time gross settlement payment system for cross-border transfers throughout the European Union.
In a worse-case scenario, the Bund yields could shoot up. In particular, real yields for Bunds could recover back into positive territory, which would further aggravate the situation in the German economy.
In a best-case scenario, European integration will accelerate. Short term, this would lead to a pooling of the sovereign risk (through eurobonds, eurobills and the redemption fund) and/or a massive intervention by the ECB in the primary and secondary markets through the Securities Markets Programme. Over the medium term, further steps would be taken towards the creation of a banking union, and then towards political and fiscal union. In this event, there would be a normalisation of the situation in the markets, as a result of which the Bund would fall back from its “unnaturally” high level.
In short – both extreme scenarios are bearish for Bunds.