Recently falling yields are a diversion from rates’ long-term drivers: inflation and tapering, which will inevitably drive yields higher on both sides of the Atlantic.
In moments like this, it’s crucial to keep the focus on the economic megatrend and catch under-the-radar signals. One of these signals came from yesterday’s disastrous Germany 15-year Bund auction. The German finance agency had to retain part of the €2.5bn target sale amount placing only €1.73bn Bunds because of extremely weak demand. The auction drew a bid-to-cover of 1.06x, the lowest ever recorded for this maturity, even though the bonds offered a positive yield when most German debt still provides negative returns.
The odd part of this story is that the market completely ignored this auction. European sovereign yields, including those of the German bund, closed lower by the end of the day.
What happened yesterday is alarming. Is anybody else besides the European Central Bank buying Bunds? That’s a crucial question for German government bonds and those sovereigns that are dangerously yielding close to 0%, such as France, Spain, and Portugal. Indeed, suppose the demand of European government bonds starts to collapse ahead of the ECB tapering. In that case, we can expect a repricing to be dramatic when the main source of support is lifted.
European sovereigns are tightly correlated to US Treasuries. Therefore, until US Treasury yields trade within a tight range, European yields will keep in check also. We expect the two markets to continue to trade in tandem until German the elections. A new government in Germany will most likely bring a much-needed change in the European bond market, which will see higher yields and tighter spreads across sovereigns.
Yet, until fall, it becomes crucial to understand whether US Treasuries will stay at current levels or not. If they do, we might not see 10-year Bund yields rising above 0% before the elections. On the other hand, if US Treasuries hit 2% before September, there is a chance that we might look at positive yielding Bunds ahead of the German elections.
The signals that we are getting from US Treasury yields are mixed. Yesterday’s bidding metrics for the $61 billion 5-year notes sale was incredibly robust. The auction drew the highest bid-to-cover ratio since September and the highest demand from foreign investors since August.
The reason why we see demand for US Treasuries picking up may be explained by the tsunami of liquidity that cannot find a house within the money market space. Fed's reverse repo volumes are constantly surging, and some of that liquidity might start leaking onto longer-term maturities. Some point to the possibility that this may be a Fed’s strategy to keep the US yield curve in check as the economy heads towards a recovery. However, we doubt such a strategy will demonstrate to be successful if inflation pressures continue to rise.