German bund yields edged higher on Tuesday after Moody’s lowered the outlook for Germany, Netherlands and Luxembourg the day before, while the ratings agency kept a stable outlook for Finland.
Moody's cited the financial burden of the AAA-rated countries amid an expected expansion in the European Stability Mechanism (ESM), rising intra-eurozone fiscal and banking liabilities, not to mention uncertainty over the size and structure of liquidity mechanisms to prop up peripheral Europe. At the time of writing, the 10-year bund rose six basis points to 1.23%.
The ratings move adds fuel to the debate over whether rising liabilities on Berlin’s balance sheet should drive core yields or whether the flight-to-perceived quality and global collateral shortage will ensure German borrowing costs are capped at historic lows, or, at the short-end, remain in negative territory.
Desmond Supple, fixed-income analyst at Nomura, shrugged off the prospect of any material sell-off in bunds amid credit risk, maintaining his 10-year 1% target. His view sums up market consensus: “Our structurally bullish bund view presumes that, as the risk of a euro break-up grows, these assets will cease to trade as yield products and instead resemble collateral assets with an embedded foreign-exchange option, whereby investors purchase bunds with a view to a possible redenomination into Deutsche marks or a rump-euro [a eurozone comprised of northern European states].”
In other words, investors will shrug off rising bond yields amid collateral demand and, in the event of a euro break-up, currency returns will offset cash bond losses, he reckons.
Mirroring the perverse rally in US Treasuries last year amid the legislative gridlock on lifting the debt ceiling, Supple says the dip in bund prices, after the rating action, represents a buying opportunity. He argues recent EU summits highlight Berlin has succeeded in capping the fiscal costs of a eurozone bailout – for now.
“In our view, one of the striking developments from last month’s EU summit was how Germany removed from consideration policy options that focused on increased fiscal resources," he says. "Instead, the summit focused on utilizing crisis response mechanisms such as the EFSF [European Financial Stability Facility] and the forthcoming ESM.”
In addition, the market is expecting structurally low-price pressures in Germany during the coming decade, traditionally a boost for bonds, with break-even rates on the 10-year note forecasting an inflation rate of 1.62% in July 2022 compared with 1.7% in June this year.
Fuelling the bullish pitch, market technicals – principally, collateral demand and a benign supply-demand dynamic – will fuel the “structural rally”, says Supple. German banks have non-German euro-denominated assets that could be sold off in any home-bias flight-to-safety sell-off, which amount to €1.46 trillion compared with a stock of actively traded bunds of €200 billion to €250 billion. In addition, the long-end of the German sovereign yield curve provides investors with rare exposure to a liquid-duration play in core eurozone fixed-income markets, Supple says.
Crucially, if the Canadian ratings agency DBRS becomes the fourth ratings agency to downgrade Spain to a BBB-rated equivalent, a 5% increase in the haircut the European Central Bank demands for Spanish government bonds will be applied across the board, affecting some €250 billion of bonds pledged by Spanish banks to the monetary authority. “A DBRS downgrade of Spain will add to collateral demand for bunds,” the Nomura analyst says.
This bullish view on core government bond yields is unsustainable since the aggressive pro-cyclical fiscal tightening among eurozone economies resembles the mistakes of the Great Depression, Michael Pettis, a well-respected China economist and expert on global imbalances, told Euromoney earlier this year.
He said Germany must run “massive” trade deficits, boosted by fiscal expansion, to shore up peripheral European export markets. This policy could in the short-term depress German growth. “If Germany fails to do this, the eurozone will break up and peripheral Europe will default on its debt to Germany," he said. "Both scenarios are negative for Germany but failure to rebalance its economy will trigger a global crisis.”
This year, influential investors, the likes of Bill Gross of Pimco and John Paulson, have grabbed the headlines, arguing German government bonds yields are unsustainably low. Their calls have ignited a debate about whether relative value trades and long cash bond/short credit default swap strategies – or vice-versa – will pay off amid on expected ban on naked buying of European sovereign default swaps, which is due to take effect in November.
However, directional bets on the German sovereign debt market are risky. The consensus from fixed-income strategists at the bulge-bracket firms maintains that market technicals, principally a global collateral shortage and liquidity demands, mean bunds can over-shoot fundamental value, even as macroeconomists, and powerful real-money investors, sound the alarm over rising credit risks in the eurozone core.