Last week, we witnessed a rather dramatic sell-off in German Bunds. The rout was attributable to a confluence of factors including, but not limited to, data which appeared to show that euro loans to the private sector rose for the first time in three years, position squaring, the frontrunning of expected positive EGB supply in May, and the suggestion from yet another financial market heavyweight that Bunds represent a compelling short opportunity especially when you can leverage your position and achieve a positive carry along the way.
Despite the sell-off and despite the fact that net supply in Germany is expected to be (barely) positive in May, it will turn sharply negative to the tune of €12 billion and €15 billion in June and July, respectively, suggesting rising Bund yields may be a transient phenomenon especially considering the fact that when supply is deeply negative, private market holders should theoretically be able to charge the Bundesbank as much as they want all the way to the depo rate floor, a dynamic which should put pressure on yields (at least for maturities of 5 years and up) going forward.
Against this backdrop, Goldman is out summarizing the dynamics of the supply/demand equation for Bunds. Here’s more:
Unlike other large economies, however, the German government sector was running a surplus of 0.7% of GDP in 2014. On current fiscal policies, as the economy expands this will likely expand, implying an even lower issuance of bonds and larger scarcity effects. We calculate that the Bundesbank will remove 80% of the central government’s gross issuance of government bonds over the next year, compared with 40% in Italy, Spain and France (where redemptions and the new deficit are larger). If the amount the Bundesbank removes from the bond market is couched in budget surplus equivalent terms (i.e., a reduction in net issuance of securities), it would be in the order of around 6% of German GDP. Going by historical relationships, a surplus of this size would lower 10-year Bund yields by 60-70bp, controlling for short rates and macro conditions. Even so, Bund yields should not trade lower than 50-75bp – which suggests there are also other factors depressing yields.
PSPP then, will soak up more than three quarters of gross supply in Germany, which is twice as much in percentage terms as what NCBs will take down in Italy, Spain, and France. Meanwhile, some 40% of purchase-eligible German bonds are in foreign hands…
The breakdown of ownership is also playing in favour of lower yields. Two-thirds of German government debt – the risk-free asset par excellence – is held by non-German residents. No official statistics are available for how the share in the hands of foreigners is divided between other residents of the Euro area and investors outside the currency union. Combining data on foreign balance sheets with anecdotal information, we believe that as much as 40% of the stock of German securities may now be held by investors residing outside EMU. A broader diversification across the Euro area sovereign markets has been held back by the large credit rating gap that still exists between the core countries and the periphery, and ongoing tensions surrounding Greece.
Finally, Goldman reminds us that the structure of PSPP has a tendency to create sell-fulfilling prophecies…
Last but not least, the ECB has stated that bonds yielding less than negative 20bp (i.e., the deposit rate) would not be eligible for purchase. Alongside this, it has set constraints on how much of each specific security it wishes to own. As the decline in yields that has followed the liquidity injections has made its way to intermediate maturities, the market has extrapolated that the Bundesbank would have to purchase a larger share of longermaturity bonds to fill its quota. This is a self-reinforcing expectations loop, where lower yields beget lower yields. Given its nature, the loop can also switch direction. As yields rise, more bonds become eligible for central bank purchases, and the price action goes into reverse. What we have seen in recent days has offered a taster of these dynamics, especially at the very long end of the German yield curve.
We would note that this type of feedback loop could be rather dangerous in a market that is becoming structurally very thin — that is, combining collapsing market depth with a “self-reinforcing expectations loop” that can quickly push long-end yields higher at the drop of a dime seems to be a decidedly risky proposition. Combine this with the fact that supply is set to go negative again in June and July which could push yields quickly lower, and the stage is set for a volatile summer in the Bund market.