How low can Bund yields fall?

The 10-year Bund yield recently hit the headlines when it dropped -0.41% below the current key ECB interest rate, the deposit facility rate. So instead of parking the available liquidity at the ECB at -0.40% cheaper, some investors preferred to buy ten-year Bunds.

ECB President Mario Draghi provided the impetus for the Bund Rallye, which led the yield of ten-year Bunds to a new all-time low of a good 20 bp below the old one. He said in his speech at the ECB Forum in Sintra on 18 June 2019 that further stimulus would be needed if economic conditions did not improve over the summer. Accordingly, the ongoing uncertainty about the EU budget dispute with Italy, Brexit or trade disputes constitutes in itself a materialisation of the risk factors. Since then, the yield on treasures has been 0.73% outside the previously valid range. The 15 bp decline in yields suggests that market participants are not entirely in agreement as to whether they consider 10 or 20 bp to be appropriate for a reduction in the deposit rate. At the same time, the Bund curve became flatter as Draghi also raised hopes of bond purchases. If the ECB were to buy according to the capital key, Bunds would benefit the most. Investors who do not park their excess liquidity at the ECB or at the short end of the Bund curve at a high price are more likely to have bet on present value gains with this prospect and have recently bought ten-year Bunds.

The question of how low Bunds can ultimately fall is also determined by the question of whether the ECB will restart its PSPP. In the short term, the prerequisites for this would be met if the risks that have led to the current yield environment materialized. These include less the smoldering budget dispute between Rome and Brussels – economically more serious are a hard Brexit or a conflagration in the trade dispute. Should deposit rate cuts go up in smoke because the USA and the EU are imposing punitive and retaliatory duties on each other or the UK is saying goodbye the hard way out of the EU, the step towards renewed bond purchases should be an easy one.

Bunds would then not only be bought because of the capital key, but above all because of their security character. In the event of an expected fear rally with widening spreads on credits and simultaneous losses on the stock markets, every investor would like to hold Bunds – not only because the repayment of the nominal is relatively certain, but also because there are also present value gains. At the same time, investors would have to prepare for declining availability. Although the collateral issue is currently not present, the past has shown that this does not have to apply unreservedly in phases of market stress. This applies all the more when balance sheet dates are approaching. Investors who are obliged to buy 10J-Bunds in the event of falling interest rates or a stock crash due to regulatory requirements could then find themselves in the situation of having to pay a significantly higher price than at present in the short term. Since liquidity is declining at the same time, these purchases could develop a dynamic that is reminiscent of the Volkswagen share’s exaggerated phase in 2008 or could take the form of an inversion of the 2/10 federal spread in the same year. The fact that it can come to exaggerations in once liquid federations, showed up with the felt denomination risk in the course of the French presidential election campaign at the beginning of 2017. The yield for treasures fell at the end of February with allegedly good chances of success of the euro-critical Marie Le Pen -0.964%. If we add the inversion in 2008 of -22 basis points for 10J-Bunds, only the range of -1.10% to -1.20% would be a very strong red line from a market perspective.

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