Easing euro crisis lowers German bonds

Havens can pose their own risks. That is the reality that holders of Germany’s government bonds now must face. The value of German bonds – considered a shelter from Europe’s debt storm during the last two years – has started to fall, now that investors sense a calming in other European waters.

Recently, the yield – or effective interest rate demanded by markets – on the benchmark 10-year German bond rose as high as 2.07 per cent, an 18 per cent increase from the previous week. Later in the day, it fell back somewhat, to 1.98 per cent.

Because bond yields rise as their prices fall, that means investors holding them now feel proportionately poorer than they did last week. A lot of those holders are big European banks, which have enough problems already without having to worry about their bunds, as German bonds are known.

The spiking yields partly reflect a shift by hedge funds and asset managers into debt issued by countries like Italy and Spain. Those offer a much higher interest rate – but are evidently not considered quite as risky as they were just a few months ago, as Europe shows signs of having muddled through the worst of the crisis.

As long as that crisis was raging, Germany’s relatively robust economy and aura of financial discipline made its bunds seem such a safe bet that the yield fell well below the rate of inflation as their prices rose.

Investors were effectively paying the German government to keep their money safe – as holders of US Treasury bonds have been doing in recent years. (Holders of Treasuries are also now experiencing a similar decline in the market value of their haven assets.) The change in European sentiment is good news for Italy and Spain because it means at least some investors no longer regard their bonds as impaired.

Italy’s 10-year bond was yielding 4.9 per cent – still a higher interest rate than Germany’s, but well off the 7 per cent interest rates and more that investors were demanding that Italy pay last November.

But there is a dark side for European banks, which have loaded up on haven bunds the last two years. Europe’s 90 biggest banks had holdings of German government debt that regulators valued last June at 489 billion euros ($645 billion).

Some analysts even speak of a bursting bund bubble. “The bund is probably the most widely held asset in European banks,” said Chief Economist at High Frequency Economics in Valhalla, New York, Carl Weinberg.

“Any further decay in a widely held asset like bunds would be unwelcome, and would contribute to a contraction in credit that I think is the next big problem for Europe.”
One problem is that many banks booked gains from German bonds when they underwent official stress tests last summer. The profits helped offset other losses and reduced pressure on the banks to raise more capital. It could be a problem for some banks if those bund profits proved to be ephemeral.

Some economists and European policymakers have watched the decline in German bonds with concern. The former Chief Economist of the European Central Bank, Otmar Issing, who remains influential with central bankers, said in a conference in Frankfurt that the price of bunds and US Treasuries had become “distorted” because of their haven status.
A member of the executive board of the European Central Bank, Peter Praet said that banks had been benefiting until recently from the safety status of their German bonds, which made it easier for them to satisfy regulators’ demands that the banks reduce risk. As a sign of the bunds’ rising value on the open market last year, the yield on the 10-year bunds went from about 3.5 per cent in April to as low as 1.67 per cent in September. Now some of those gains are turning into losses.

“What is the potential impact of that distortion?” Praet asked. The answer is probably that no one knows. Detailed information on banks’ current bond holdings is lacking. Many will certainly benefit from the recovery by Italian and Spanish bonds, as well as the return of relative calm to European financial markets. But any big shift in such a huge market, especially when prices had reached levels widely considered being extreme, offers a potential for disruption.

Much depends on how much more bund prices fall, and their yields rise.
Gianluca Salford and Aditya Chordia, analysts at JP Morgan in London, forecast in a note to clients this week that the yield on the 10-year bund would not rise above 2.2 per cent. That would be about the same level as in December.

Some analysts even say that moderately higher yields on German bonds would be healthy. The resulting decline in the value of the bonds “is not necessarily pleasant news for German banks,” which have large holdings of their own country’s debt, said a senior fellow at Bruegel, a research organization in Brussels, Nicolas Veron.
But, “I’m not too worried given the levels we have which are not very high,” Veron said. “If we went to significantly higher bond yields, 3 or 4 per cent, it would be an entirely different situation. But we’re not there and I’m not sure we’re going there.”
An auction of German bonds showed that they retain their allure.

The government sold debt maturing in two years at a yield of 0.31 per cent. Shorter-term bonds almost always have lower interest rates than longer-term bonds. That was up from 0.25 per cent at the previous auction on February 22, but still well below the 0.51 per cent that buyers bid last September. Germany also further burnished its reputation as a fiscally prudent country, as Chancellor Angela Merkel’s cabinet approved a budget plan that aims to cut the government deficit to just 0.35 per cent of gross domestic product in 2014, two years earlier than previously planned.

The ratio was 1 per cent for 2011 – compared with 8.5 per cent for Spain.
And yet, a disruptive lurch in German bond prices is still a risk. Hedge funds and asset managers, who are the most active traders, stand to make immense profits by dumping German bunds and buying longer-term bonds from so-called peripheral countries like Spain and Italy. These investors are betting that the worst of the debt crisis is over, and yields of peripheral country debt will continue to fall in relation to German debt. “If you time this right, this will continue being the trade of the year,” said A Managing Director at Credit Suisse in Frankfurt who specializes in debt, Mark T Muller. “Bunds are probably overvalued and some other countries are undervalued. There is money on the table.”
The most common explanation for the rise in German bond yields is that they are coming back to more normal levels as fear of a eurozone Armageddon subsides.

But another reason for the yield surge may be that investors see potential weaknesses in Germany. If the crisis heats up again, as many analysts say it will, Germany is the country that would bear the greatest share of the cost. Its creditworthiness could then slip.

“Whenever there is a disbursement to a Greece program or a Portuguese program, Germany is on the hook for roughly one quarter of the bill,” said Weinberg of High Frequency Economics.

He is also skeptical about another premise for Germany’s status as a refuge from the financial crisis: that it has a robust economy. Weinberg noted that the German economy shrank in the last quarter of 2011, and that recent data shows a slowdown in orders to German manufacturers.

“Based on the numbers I see,” Weinberg said, “the notion that Germany is safe as an economy doesn’t hold any water.”