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.