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Scarcity of collateral will contribute to European steepeners until inflation concerns revive
Summary: Buba’s decision to stop paying interest on domestic government deposits provided fertile ground for the German yield curve to steepen today. If 2-year Schatz yields close below 2.95%, they will enter a bearish trend that might take them as low as 2.45%. Yet, as we approach the fall and inflation remains elevated, short-term yields are poised to rebound before a bond bull market forms.
The Bundesbank’s decision to bring interest on domestic government deposits to 0% revives one of the most debated problems in the European bond market: the scarcity of German government bonds, hence of collateral.
Buba's tweak implies that deposits, once held at the central bank, will flee the facility and look for high-quality higher-yielding securities: short-term German sovereigns. Yet, long-term German yields remain correlated to rising US Treasuries, resulting in a steepening of the German yield curve.
Buba's decision will provide fertile ground for the German yield curve to steepen, proving supportive for Schatz.
Two-year German government yields are currently testing support at 2.95%; if they close below this level and the RSI breaks below 40, they will enter a bearish trend, which could take them to 2.66% or even lower to 2.45%.
Yet, this might not be the beginning of the European bond bull market. Indeed, the ECB's sole mandate is to maintain price stability, hence, to bring inflation to its 2% target.
However, inflation expectations show that price pressures have yet to be resolved. The 5-year, 5-year EUR forward and the ECB Survey of Professional Forecasters show that inflation might remain above target for a long time.
While a recession in Germany might help bring inflation down, we cannot exclude that with a policy rate of 3.75% and core inflation at 5.5%, more monetary policy tightening might be warranted later in the year.
Moreover, less demand from Japanese investors and higher US Treasury yields might contribute to higher Schatz yields in the fall.
Therefore, although we remain constructive on steepeners, we recognize the risk of a setback to materialize between September and October as inflation concerns revive, putting at risk short-term sovereigns before a proper bull bond market begins.