German government bond yields may need to get very negative for the euro to weaken much further. And it could easily happen (update)

In January I argued that negative German government bond yields would be a rational response to the rising probability that the euro breaks up and Germany reintroduces the Deutsche Mark (see here).  This was because German government bonds have significant optionality.  Assume that the Eurozone is forced to reintroduce national currencies – if you are living in Spain, then a German government bond yielding -0.5% won’t necessarily provide the investor a -0.5% return if held to maturity, it could result in a capital gain of perhaps 40% since the Deutsche Mark would significantly appreciate versus the new Spanish Peseta.

German 2 year government bond yields did indeed turn negative on May 31st, while 2 year US Treasury yields have remained little changed since January.  The euro has weakened so far this year, and the correlation that I discussed in January has continued to hold reasonably well.  The chart below is an update from January’s blog comment.

German government bond yields have sold off in the last two weeks, prompting speculation that Germany is becoming the next Eurozone country to be hit by the bond vigilantes.  I disagree, and believe this is much more to do with profit taking of some very long positioning ahead of Greek elections.  The investor base seems to have moved from extremely overweight Germany to very overweight Germany.  As is always the risk with such crowded positions, the sell off that began at the beginning of June resulted in a number of banks and leveraged investors falling over eachother stopping eachother out, leading to a further sell off. It is reminiscent of the last notable wobble in Germany that occurred in November following a weak German auction, but it didn’t take long for the bund rally to resume back then.  The long term trend of deposit and capital flight from Southern Europe to Northern Europe remains in place as investors become increasingly concerned of the risks of Eurozone breakup, and this should continue to support German government bonds.

How negative can German government bond yields get?  It’s interesting to look at Switzerland, where five year government bond yields are now negative, i.e. if you want to buy 5 year Swiss government debt, you have to pay them for the privilege.  The reason for negative bond yields in Switzerland is all to do with growing speculation that the Swiss franc peg against the euro is unsustainable (or the euro will cease to exist), and in the event that it breaks, investors would realise a potentially large capital gain in owning Swiss government bonds. In a similar way, Denmark 10 year government bonds yield 10 basis points less than German government bonds of the same maturity since presumably if the Eurozone begins to splinter then one of the first things to break would be the Danish krone peg against the euro.   As Eurozone stress increases, German bund yields could easily become very negative, and across the whole yield curve.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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Discuss Article

  1. Ignacio Cepeda says:

    But, don’t you think that the Deutsch Bond sell-off in the last two days is inconsistent with the uprising tension ahead of Greek vote. To me seems to be a movement triggered by the idea of a possible solution of the crisis.
    Best Regards.

    Posted on: 14/06/12 | 10:54 am
  2. Justin Pugsley says:

    Certainly the scenario depicted here is a very plausible one, especially if the Greeks effectively vote to leave the Euro over the weekend or just produce another inconclusive result.

    But I don’t think anyone should under-estimate the enormous determination of Eurozone policy makers to keep the zone together, even Merkel now talks of political union and she must realise what this means in terms of making vast payment transfers from the north of Europe to the south.

    As the Eurozone effectively moves towards a super-state, because that’s effectively what’s happening now as the preferred solution to the crisis by policy makers, the business community and investors, I think longer term this could be quite negative for German bunds – especially if the Eurozone moves towards Eurobonds to replace national bonds. Those would surely be higher yielding than German bunds, unless the ECB can be coaxed into giving this new market unlimited support.

    The Germans are opposing this, but there does seem to be a trend whereby the Germans oppose something only to eventually agree, especially if the measure in question has strong French backing – such as Eurobonds.

    And besides political and fiscal union will place great strains on Germany’s finances in the future, turning around these peripheral Eurozone economies will take many years and in the meantime could stoke huge political tensions and could conceivably bankrupt Germany if she decides to put everything on the line to save the Euro.

    So should the markets start to take the view that the Euro will be saved due to the fiscal union they’ve been calling for, they could ironically re-evaluate German bunds on the basis of Germany’s potentially open-ended financial commitments – but we’ve not reached that stage yet in the crisis and may never do so.

    Posted on: 14/06/12 | 11:00 am
  3. Frank Strippel says:

    Thank you for this very special point of view regarding present and even more to be expected flow of funds. Particulary today it is the true art of a modern portfolio management to combine fundamental and political issues.

    Posted on: 14/06/12 | 11:30 am

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