Land of the Rising Bund

by Richard Barley

Wall Street Journal
May 14, 2012

German bunds are starting to be grouped with Japanese government bonds: No matter how much investors think yields are too low already, they keep falling. Ten-year German yields Monday plummeted to a record low below 1.44%. With German inflation at 2.3% and 2012 growth forecast at 0.7%, bunds look very expensive. But rising fear of a euro-zone break-up, a slowing economy and scarce alternatives mean yields could go lower yet.

The resurrected debate about a Greek euro exit is the immediate driver. While policy makers are trying to argue that a Greek exit might be manageable, it could easily lead the market to question the viability of the euro as a whole. The yield gaps between German bunds and Spanish or Italian bonds imply a 15% probability of a euro-zone break-up, Citigroup analysts estimate, meaning low bund yields are partially a bet on changes in exchange rates. If investors think a new German mark might rise 10% against other European currencies—and it could be far more—then each 10% rise in the probability of a break-up adds one percentage point to bund prices, pushing 10-year yields down around 0.1 point. Added to that, Germany is a net creditor to the rest of Europe; if German investors were to bring cash home on fears of a euro meltdown, that too would drive bund yields lower.

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