Sell German debt, urges Kames Capital’s David Roberts

David Roberts, joint head of fixed income at Kames Capital, warns investors in a note that they should consider selling German government debt as its value risks falling sharply.

The events of recent months have created an almost insatiable demand in the market for German government debt. To many observers this market has been false. Yields have plummeted and prices have risen as institutional and retail investors alike have clamoured to take advantage of bunds’ perceived safe haven status. In many cases the buying has owed nothing to valuation or fundamental metrics. German status as one of a shrinking club of AAA-rated borrowers has been seen as sacrosanct. Recent events suggest that this favoured nation status may be coming to an end.

The fundamental argument – inflation and unemployment

Consumer prices are running around at a 2% annual pace. If we still lived in a Bundesbank world then this would be in line with longer-term averages, towards the top end of the central bank comfort zone. Rather than looking to cut interest rates and stimulate the economy, the Bundesbank would have considered tightening policy. A 2% increase in the rate of inflation obviously means that buying 10-year bonds yielding 1.5% locks in a negative real rate.

The inflation situation could start to deteriorate soon. The domestic labour market is now incredibly tight. According to the International Labour Organisation, aggregate German unemployment is now under 6% and trending lower. In several states within the industrial heartland the number is perilously close to 3%. The impact is already being seen, with major labour organisations such as IG Metall successfully winning wage settlements well above 4%.
Of course investors (at least those holding bunds) are also becoming concerned that Germany may be about to embark on a fiscal expansion programme. Certainly, Chancellor Merkel seems more inclined to consider the idea – it is already on the agenda of increasingly popular opposition parties.

The technical argument – the Swiss Central Bank

Global central and commercial banks have been big buyers of German assets. Such institutions buy for various reasons, seldom though is the buying dictated by value. A classic case in point is the Swiss National Bank (SNB). At the end of 2011 the SNB balance sheet was CHF346 billion, CHF76 billion higher than a year earlier. Most of this came from growth in foreign exchange reserves – in short, the SNB has been selling as many Swiss francs as possible and buying euros to prevent domestic currency appreciation.

The euros bought through this process have to be invested somewhere – 84% of SNB balance sheet assets were held in AAA rated government debt and of that, nearly 60% in Europe. And balance sheet expansion in 2012 has been even more rapid. In short, on conservative estimates the SNB holds in excess of €200 billion of bunds. Compare that with UK gilts where the number held is closer to €20 billion. According to SNB: “Most of the investments are held in the form of government bonds, with government bonds from European core countries and the US accounting for more than half of the investments. The predominant part of the investments [at the end of 2011 it was 83%] bore the highest rating (AAA).”

Whilst there is little evidence that the Swiss will stop buying anytime soon, it is worth remembering that it, like most central banks, do not need to own these assets and any reduction in buying (let alone selling) will remove one of the major drivers of price appreciation.

The political argument – Spain, the EFSF and the ERF

In November 2011 investors in bunds were given a rude awakening. Concerns that the eurozone crisis had started to impact on Germany as well as peripheral countries led to a (temporary) flight from German debt. The chart below shows a huge spike in German yields relative to US Treasuries. In the past couple of years buyers of bunds have normally been paid less than buyers of US Treasuries. This changed with a move higher by 50 basis points in the space of a few days. The move cost investors around 7% lost value – or put another way, 4.5 YEARS’ worth of incomeThis appears to have been a warning shot, not heeded by many investors. Shortly after, the ECB announced its three-year Long Term Refinancing Operation. Stability returned to markets and the ‘European problem’ once again became the ‘peripheral problem’.

In recent days though, Germany again appears to have been sucked into the vortex. Firstly, the plan to recapitalise Spanish banks with up to €100billion was seen as pro-risk – bad for bunds. Then, on reinvestigation the plan appeared to raise more questions than answers. However instead of rising, bunds continued to fall. Market commentators became concerned as to the funding mechanism of the plan, worries arose that Spain would opt out of the EFSF and place greater future burden on the remaining core countries. Although not necessarily the case, it appears the damage was done, questions were asked about the ability of Germany to support an increasing number of peripheral problems and still maintain that AAA rating.

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