Something Weird Is Going on With German Debt

(Bloomberg Opinion) -- Falling yields on German government debt is the sign of a classic “risk-off” mentality. As fear grows, investors plump for safety. But where's the crisis in Europe?

Yields on 10-year bunds have fallen steadily by 30 basis points in the past two months. And German notes out to eight years are now in negative territory. It's hard to fathom why. At the start of October, we were only seeing negative yields out to five year maturities.

Italy's budget battle with Brussels has been alarming, but it seems to be calming down somewhat as Rome's populist government talks about compromise. Italian sovereign yields have fallen more than 50 basis points in the past fortnight. Meanwhile, Wednesday's European purchasing managers surveys – barometers of economic activity – were fine, with a strong showing in Spain and an above 50 reading from Italy's service sector.

The euro zone's finance ministers even managed this week to strengthen the monetary union's crisis defenses. So, while there are still broader worries about Europe's economy, there's no existential fear around EU schisms or the euro. The latter is in a fairly steady range to the dollar.

Yet bund yields are at levels not seen since the lead-up to French elections in May 2017, when Marine Le Pen was in the running. There's always a rush for high-quality collateral in banks' year-end funding scramble. But there's more to this than short-term liquidity pressures.

Looking across the Atlantic is probably the best guide. Federal Reserve rate-hike expectations are certainly taking a hit, which is driving down yields in other major markets. The market-implied probability of a 25 basis point increase, expected at the next Fed meeting on Dec. 19, is down to 74 percent compared with 80 percent on Monday. Looking further out, there's just a 15.5 percent probability of the quarterly rate-hike cycle still being in place in June.

There have been some dovish noises in Europe too. A Reuters story Wednesday, citing European Central Bank sources, suggested that a renewed “targeted long-term repurchase operation” might be offered to euro zone banks next year on a permanent basis. These so-called TLTROs are a way of providing super-cheap funding to lenders that can put up eligible loan collateral, so their potential renewal suggests the ECB's governing council is looking at ways to soften the blow of ending QE.

Still, no one should get carried away. Few traders think the ECB will deviate from its plan to end new bond purchases this year, even if it will be more flexible about how it reinvests its 2.56 billion trillion euros ($2.9 trillion) of holdings.

Bund yields at 25 basis points, with no realistic chance of QE being extended, are illogical and merely a function of a repricing of U.S. rate expectations. They're unlikely to stay like this long into the new year.

To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

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