Prepare for higher German bond yields

The German election will bring higher Bund yields

The German election is becoming more uncertain. Recent polls show that the SPD has overtaken the CDU for the first time in 15 years, polling at 23%, just a point over Angela Merkel's party. Additionally, the Green party is in third place with 18%, indicating that an SPD-CDU/CSU-Green coalition is likely.

It's impossible to draw conclusions yet as anything is possible in the next five weeks. Yet, amid a SPD-CDU/CSU-Green coalition, we believe that Bund yields will rise.

Firstly, fiscal spending will increase. The SPD wants to propose an "obligation to invest", setting a minimum percentage of the budget for investments in schools, research, transportation and energy. At the same time, the Green party is looking to relax Germany's debt brake.

Secondly, all parties, including the FDP, seek a better European integration and are open to give the European Parliament the right to initiate legislation. Although there is a divergence of views over the EU coronavirus recovery fund, it's becoming clear that the issuance of common liability bonds is here to stay despite who's winning the elections.

The two points above reinforce our idea that German Bund yields are meant to rise with the German election. Also, a new government has the potential to accentuate spread compression among various European sovereigns during the last quarter of the year.

Expect Bunds to suffer losses amid surging US yields in autumn

Although the recent drop in Bund yields make sense as growth loses momentum, we have reasons to believe that tumbling yields in the United States have caused the largest part of Bund yields' drop. Indeed, the correlation between Bunds and US Treasuries has been rising to nearly one since June.

As indicated in this week's "Fixed income market: the week ahead", we expect US Treasury yields to resume their rise this fall. By November, the Federal Reserve will begin to taper, the US Treasury will increase its Balance Sheet to refinance existing debt, growth momentum will resume, and inflation will be sustained. Basically, the bond market is running the risk to see a re-emergence of the reflation trade in conjunction with tapering and an increase in Treasury bond issuance. We believe that all of this will apply enough pressure to push 10-year yields above 1.70% and possibly test 2% in yield.

Within this scenario, Bund yields will chase their US peers. However, they will not sell off as much as their American counterparts for the simple reason that Bunds lack free float. A recent report from Bloomberg Intelligence shows that while the free float on US Treasuries is 65%, the one for German Bunds is only 25%. Additionally, suppose we include into the calculation bonds held for regulatory purposes as high-quality liquid assets. In that case, Bunds' free float drops to less than 10%. For this reason, Bunds will be less volatile than their American counterparts.

How high can Bund yields go?

It is a  hard question to answer as it depends on the outcome of the German election and the rise of yields in the United States.

We talked about two possible outcomes in our quarterly outlook: 10-year Bund yields rising to 0.2% or 0.6%. Following the recent dive in 10-year yields, the latter target seems far too aggressive. We, therefore, believe that in the most bearish scenario, we will see 10-year Bunds rising as much as 0.20%. As a new German government is established, we might see Bund yields rising to test resistance at -0.25%. As US Treasury yields soar in the fall, we might see Bund yields breaking this level and test resistance -0.15% to enter in a fast area that could take them to 0%.