The German Bund conundrum: Short or long in 2012?



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Tobias S. Blattner, Economic Research
Daiwa Capital Markets Europe Limited
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19 December 2011

Predicting yields on euro area bonds has become a lot harder since the outbreak of the debt crisis. Before the crisis, movements in yields mainly reflected changes in the outlook of major economic fundamentals, most notably projections for growth, inflation and monetary policy. The crisis, however, has added an important and (even) less predictable dimension: the degree to which national debt is considered a ‘safe haven’.

From this perspective, recent investment flows are a conundrum. Throughout the crisis, German Bunds have served as the prime safe haven, with yields along the curve touching record lows a few weeks ago, despite the supposed common destiny (“Schicksalsgemeinschaft”) Germany shares with its fiscally-troubled neighbours. A dreadful auction in November, when Germany couldn’t place around 35% of its bonds, remained the exception to the rule.

But are Bunds likely to retain their safe-haven aura in 2012? If the crisis remains on a ‘slow burn’ with neither a resolution one way or the other, nor an escalation, chances are that they will. However, once the crisis is resolved – for better or worse – German Bund yields seem bound to correct.

What will happen to Bunds if we have a ‘happy ending’? If the debt crisis can be resolved quietly, with investor sentiment recovering gradually in the course of the year as opposed to a sudden and sharp correction following a ‘big-bang-solution’, some of the safe-haven flows would inevitably reverse, pushing yields higher.

By how much? Applying the estimates of a recent IMF study – which identifies the ‘fundamental’ drivers of bond yields over the medium term to be the policy interest rate, inflation, and government deficits and debt stocks – we estimate that the impact of safe-haven flows on long-term Bund yields is likely to be in the range of 110 to 120bps.

Let’s look at some evidence. In 2010, when Greek 10Y bond yields doubled in less than six weeks, triggering the country’s bailout package and the establishment of the EFSF, 10Y Bund yields fell by 95bps within four months. However, at the same time – if one takes the IMF or ECB forecasts published at the time as a guide – growth prospects for the German, euro area and global economies actually improved, causing projections of fiscal deficits to fall and expectations for tighter monetary policy to increase (see charts 1 and 2). So, based on fundamentals, yields should have increased by around 15bps, implying that the impact of safe-haven flows on German 10Y Bunds during this episode is likely to have been in the vicinity of 110bps.

This year, short-term volatility aside, 10Y Bund yields fell by 182bps from their peak in April (3.49%) to their historic low of 1.67% in September when the crisis fully engulfed Italy and Spain and threatened to blow the euro apart. According to economic fundamentals, however – the pronounced change in expectations for future monetary policy in particular (see chart 3) – the ready-reckoners suggest that yields should have fallen by only 61bps, making the residual of 121bps our estimate of the impact of safe-haven flows on 10Y Bund yields this year.

These estimates, however, are based on the assumption that euro area leaders will be able to preserve the status quo – a scenario that looks increasingly unlikely to us the longer the crisis drags on. In fact, the euro’s survival seems more likely to be based upon a medium-term commitment to some form of debt socialisation in the euro area, either indirectly through the ECB (where Germany is liable for nearly 30% of its potential losses) or, most likely, through the issuance of common Eurobonds, with German tax-payers guaranteeing directly the debt of fiscally troubled member states. Both outcomes would ultimately lead to a substantial increase in the credit risk of German debt, putting upward pressure on yields.

Alternatively, if the crisis ends in tears, with some member states, including Italy, defaulting on their debts and perhaps even introducing new currencies, the economic costs for all countries in Europe would be huge. Germany could not emerge unscathed. Recent studies suggest that this scenario could potentially imply costs to the German government of up to 25% of GDP in the first year, caused by widespread corporate defaults, the need to recapitalise the banking system and a collapse in international trade.

To us, that looks a conservative estimate given that Germany’s debt-to-GDP ratio rose by 9% in the year following the default of Lehman. But it is clear that higher debt and a sharp fall in economic activity would rapidly lift Germany’s government debt burden to well above 100% of GDP. And while the partial or total disintegration of the euro would result in a major repatriation of German funds invested abroad – much of which would find its way back to the Bund market – the destruction of German wealth caused by the collapse of the euro, together with reasonable concerns about the sustainability of Germany’s debt, would again likely result in a sharp rise in Bund yields.

Under these scenarios, where might Bunds be heading?  The IMF study estimates that a 1ppt increase in the debt-to-GDP ratio leads, on average, to a 5bps increase in long-term yields. So, in the event of a happy ending, we calculate that 10Y Bund yields might increase by around 50bps – on top of the 110 to 120bps of reverse safe-haven flows – with the adjustment reflecting the difference between the expected German (81%) and euro area (91%) debt-to-GDP ratios at end-2012.

If the euro were to break up, however, while the uncertainties from such an extreme shock are inevitably huge, the IMF’s rule of thumb suggests that investors may demand about 130bps in additional risk premia in the event that Germany’s debt-to-GDP ratio was to increase by 25ppts.

While all of these estimates should naturally be taken with a pinch of salt, they provide a helpful gauge for the (one-way) adjustment in German Bunds likely to be seen once the crisis is resolved – whether or not the euro survives. And with the clock ticking to save the single currency, we expect the adjustment to occur sooner rather than later as the current policy of muddling through looks unlikely to survive for much longer (please view link to previous blog).


Tobias S. Blattner
Euro area Economist


Chart 1: German 10Y Bund yield and euro area real GDP

Source: Bloomberg and Datastream

 

Chart 2: Change in market expectations of future ECB policy in 2010

Source: Bloomberg

 

Chart 3: Change in market expectations of future ECB policy in 2011

Source: Bloomberg

 

 

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