Ten-year Bund yields have lain below the 1% level since autumn 2014 and have even dropped into negative territory driven by falling inflation and the ECB purchase program. Only recently have we started to re-experience a slight increase in bond yields here in Germany, too, given less expansive monetary policy worldwide and a growth pickup. The related question arises whether this increase will continue and whether we are moving into a market phase of rising yields long-term.
We have identified monetary policy, demographics, the inflation dynamics and market liquidity as the drivers of the past years‘ yield changes. ECB monetary policy will remain expansive on a sustained basis over the coming years. Although the central bank will end its purchase program, the subsequent hike in key interest rates will not prove too pronounced. Experience in the USA has shown that markets already reflect this trend at an early stage, restraining the further rise in yields which is additionally limited by sustainably high central bank balance sheet volumes. The inflation dynamics will not contribute much, as the correlation between the labour market and inflation is not very pronounced due to both temporary as well as structural effects. With their anti-inflationary effect, demographic factors are catering for lower capital market yields long-term. Moreover, the shortage of Bund securities due to diminishing issuance activity and constant-to-rising investor demand, accompanied by an unchanged ESCB reinvestment policy, are holding yields down.
In our analytical work, we arrived at the conclusion that the long-term yield level on ten-year Bunds is described by potential growth and the prevailing inflation trend. We currently assume potential growth in the 1.25% range. If we observe the trend in both the inflation and core inflation rate for the past five years to describe the prevailing inflation trend, the average in this case stands at around 1%. In sum, we thereby arrive at a long-term target of slightly above 2% for ten-year Bund yields. If we deduct from this the effects of ECB policy for its key interest rate and its balance sheet (30 basis points), demographics (20 to 30 basis points), the Phillips curve (25 basis points) and Bund scarcity (30 basis points), the magical 1% level currently appears to represent the anchor point. We believe that these effects, apart from the demographic component, will wane over time. Given the normalisation of ECB policy (key interest rates and balance sheet) and equally the macroeconomic correlations, this will gradually generate a largely distortion-free ten-year Bund yield up to the end of 2022.