Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 01 March 2017 at 10:00 GMT

Weekly Bond Update: What's behind the steep rally in Bunds?

Fixed Income trader / Saxo Bank
  • Optimism has come back to major economies
  • ECB could further taper its bond purchase programme later this year
  • However 2-year Bunds are now close to minus 1% yield
  • Fear of Le Pen might drive investors into Bunds
German Bunds as a safe harbour. This one is in Flensburg, 
the very North of the country. Photo: Shutterstock

By Michael Boye

This year the Eurozone economies have looked poised to break free of the lacklustre slow growth environment that has trapped them for years, but as we pointed out a few weeks back, political uncertainty and instability have been the dominant themes for the region as of late.

The optimism has otherwise been well founded in improving fundamentals and consumer confidence. The positive sentiment from overseas following the election of new president Trump and the entire reflation trade that has ensued also undoubtedly has underpinned the positive vibe. The Federal Reserve is widely expected to respond, by hiking its benchmark interest rate at least two times this year.

Already in January, the European Central Bank, reacted to the optimism by tapering its monthly bond purchases, a decision we think could very well be repeated with further tapering later this year.

Nevertheless, Bunds - the German government bonds - are trading near year high levels with corresponding year low yield levels. In fact, the 2 year German government bond yield touched a remarkable all time low earlier this week at minus 0,96%.

The 2 year German government bond yield has been negative since 2014

Source: Bloomberg

So what is the reasoning behind this remarkable move. Did the macro data suddenly drop off a cliff? Certainly not. Last week, the Eurozone composite Manufacturing PMI - widely regarded as one of the most indicative numbers of economic sentiment - was reported at a multi year high index of 55,5. Similarily the IFO index, the German Business Climate indicator, equaled its highest reading since 2011 at index 111,0.

What about the equity markets then? Surely, they must be in full panic over the political risks. Not exactly either. The German DAX index traded above index 12,000 for the first time ever just last week, and the index has gained 24% year over year and 3% this year to date. The US Dow Jones index blasted through 20,000 for the first time ever and is up by 6% year to date, as the market anticipate new economic stimulus from the Trump administration.

But then the European Central Bank must have backed down from its long-held (unspoken, granted) promise to keep bond markets afloat. European government and credit bonds would inarguable be in a much worst place had it not been for the central banks unprecedented support of low (negative, even) yields and bond purchases in government as well as corporate markets. The latest evidence to surface was the almost casual remark in the minutes from the ECB's January 18-19 meeting, published earlier this month, that “limited and temporary deviations” from the capital key “were possible and inevitable”. The capital keys govern the share of bond purchases which are allocated to each member country where Germany and France are heavy weighters by default. Deviations would almost surely mean a bigger allocation for peripheral countries such as Spain, Italy, Portugal and maybe even Greece. Which would in turn mean less demand for German government bonds, and thus another reason to expect fading demand here.

That leaves us with the most obvious, yet perhaps in our view exaggerated culprit, namely the very political uncertainty that we discussed in detail earlier. But also here, there has been clear progress. Greece is no longer an imminent concern - okay, that might be a bit bold given recent history - but following the news that Athens has agreed to new negotiations with the European Union there now at least seems to be a clear path with all parties working towards a long-term solution, and the 10-year Greek government bond is now trading below 7% for the first time since late January in response.

Spread between French and German bonds contracts as Macron-campaign gains momentum

Source: Bloomberg

In France, momentum is building for independent French presidential candidate Emmanuel Macron, who has now emerged as the clear front runner (not counting Le Pen) in the first round of the election. In the second round of the election, Macron is polled to subsequently beat Le Pen by a clear margin of 61 percent to 39 percent. While the spread between French and German government bonds have contracted a bit recently, the fear of a Le Pen presidency still seems to be hunting bond investors though. Among other things, the Front National presidential candidate has woved, that she would remove the country from the Eurozone and thus re-denominate French debt, a move which S&P said would trigger a default and undoubtedly would lead to a break-up or significant reformation of the Euro currency itself. 

One way investors could protect themselves against this risk, would be by moving into German bonds, as - presumably - the new German Euro or the re-incarnation of the Deutsche Mark would be the strongest currency. Perhaps this is the real reason behind the strong support for German government bonds, which could quickly prove to be meeting trouble halfway - baring a Trump-like comeback win for the Le Pen campaign of course.

— Edited by Clemens Bomsdorf

Michael Boye is a fixed income trader at Saxo Bank


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