Uncertain Outlook A Bursting Bond Bubble?

Many investors have been wrong-footed by a sudden slump in German bond prices. After months of predictability, the outlook for Europe and the European Central Bank is uncertain once again.
Is the bond bubble about to burst?

Not even Bill Gross expected such a rapid slump in the price of 10-year German government bonds, or "bunds."

The star investor last month tweeted that the most important European government bond was the “short of a lifetime” — meaning it offered a unique opportunity investors who bet that prices of derivatives will fall. But he said the timing of the fall depended on the actions of the European Central Bank. He hardly expected his comment to be the trigger for the sell-off itself.

That seems to be exactly what has happened. The Frankfurt-based ECB hasn't done anything to warrant the fall in bund prices that started at the end of April and has shown no signs of easing up in the past week.

What was started by Mr. Gross, the former co-chief of the world’s biggest private asset manager, Pimco, was followed by similar remarks from another high-profile bond investor Jeffrey Gundlach. Added to that last week came some actual hard data – news of a surprisingly strong rise in inflation for Germany in April.

This mix of facts and sentiment sufficed to turn the bond market on its head – not just in Germany but in Spain, Italy and other European markets. Speculation has intensified that bonds are caught in a price bubble triggered by the ECB’s massive bond buying program launched in March of €60 billion, or $68 billion, a month.

Market players have all but forgotten that in mid-April, German bonds seemed headed for negative yields after the yield on 10-year paper had shrunk to 0.05 percent. Since then, bond investors have been hurling bunds out of their portfolios at an almost unprecedented pace, causing prices of these bonds to drop and yields to rise. On Thursday, 10-year bunds yielded as much as 0.8 percent — an enormous rise in such a short time.

The bund future, a key barometer for the market, is fluctuating more wildly than at any time since the summer of 2012 at the height of the euro zone debt crisis.

Bond analysts are at a loss for explanations.

The rapidity of the yield move without an ECB response has already undermined the credibility of the central bank’s bond purchases, and is weakening the potential of the programme to reach its goals. Jan von Gerich, Bond analyst, Nordea

“Reasons for this move are still being sought,” strategists of Nationalbank Essen commented. Much of it is likely down to investor nervousness, because many had been wary of the bond bonanza that preceded this slump.

Long-term damage may have already been done. Jan von Gerich, an analyst with the Scandinavian bank Nordea, in a research note said the failure of the ECB to respond to the market jitters "has already undermined the credibility of the central bank’s bond purchases, and is weakening the potential of the program to reach its goals." Even if bond market yields start falling again in future, he said confidence has already been eroded.

The jitters have not been limited to Germany, Europe's largest economy, which emerged from the continent's debt crisis of the past five years largely unscathed. The yields on 10-year Italian and Spanish bonds rose as well, to as high as 2.03 percent and almost 2 percent respectively. At the start of May the yields had been around 1.5 percent.

The ECB triggered the price surge when it launched its bond buying program in March as part of its strategy to pump €1.14 trillion into the euro zone economy by end-September 2016, and many other investors piled into the market. Betting on bunds looked pretty safe. Their gains were compounded by the absence of fresh paper coming on the market, because Germany is determined to balance its budget this year instead of hiking its public borrowing.

Even after the market correction, yields still look low compared to their long-run averages, but they may no longer be as low as the ECB had hoped.

 

The Pendulum Swings-01

 

The ECB wants its bond program to reduce the interest rates that banks charge for loans, thereby boosting bank lending, economic growth and inflation. If it succeeds, bond yields should eventually rise as well because they tend to move in line with the rate of inflation – but the swing shouldn't have started this early. The ECB expects that the euro zone inflation rate will rise from zero now to to 1.5 percent by the end of 2016, when the ECB's bond program is likely to come to an end.

Big investors have been accelerating the bond price falls because they shield themselves from losses through automatic selling once prices hit certain levels. Many hedge funds had evidently bet on rising bond prices and got out of the market when it turned south, said analysts at Landesbank Baden-Württemberg.

 

Mario Draghi, Bill Gross. Sources: AFP, Bloomberg

 

 

Other global markets have been shaken by the bond turbulence. The dollar has depreciated against the euro, while share prices have also fallen.

“Given the extreme valuations recently, a correction was quite warranted,” said Sonja Marten, an analyst at DZ Bank.

The euro climbed as high as $1.1391 on Thursday, a powerful rally from its 12-year low of $1.047 in mid-March. Germany’s DAX index of 30 leading shares has also fallen sharply from its all-time high of 12,391 points in mid-April.

But what’s going to happen now? Analysts at WGZ Bank, a cooperative bank, said he believes a bond price rebound is now “overdue.”

Elmar Völker, an analyst at Landesbank Baden-Württemberg, said: “The ECB will remain active as bond buyer and thereby prevent an excessively strong rise in yields.”

Bond investor Mr. Gross, the former co-head of Pimco, would presumably welcome a calming of the market. At his new employer, investment firm Janus Capital, he’s been betting on bunds fluctuating less than the market expects. That stance has left his fund with considerable losses since the slump in bund prices that he himself helped encourage.

 

Andrea Cünnen, Anke Rezmer and Susanne Schier cover bonds, stocks and their investors for Handelsblatt in Frankfurt. Christopher Cermak of the Handelsblatt Global Edition also contributed to this story. To contact the authors: [email protected], [email protected] and [email protected]