Investors Can't Get Enough German Bonds

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07/04/2018 | 05:16 pm

By Jon Sindreu

Even as central banks tighten the taps on monetary policy, hunger for German debt remains undiminished.

Yields on U.S. Treasurys continue to rise, but those on German bonds are falling, dragging funding costs lower across Europe.

Investors are buying bunds amid slowing eurozone growth, a flight to safety from geopolitical risks and as the European Central Bank indicates that it will keep supporting the bond market even as it rolls back the easy-money policies of the past decade, investors said.

On Tuesday, yields on 30-year German government bonds sank below 1% for the first time since April of last year. They headed lower early Wednesday, but later edged up to close at 1.009%. At the start of the year, they were trading at around 1.3%. Bond yields move in the opposite direction as prices.

The biggest moves have been among longer-term bonds, but German debt has rallied across all maturities. Yields on five-year bonds, which briefly turned positive earlier in the year, are now back to below minus-0.3%.

This wasn't supposed to happen; ever since the Federal Reserve began to nudge up interest rates, pushing yields on U.S. bonds higher, investors have been predicting a selloff in negative-yielding German debt.

"At the beginning of the year I was absolutely not expecting levels to be hovering where they are today," said Henrietta Pacquement, a fund manager at Wells Fargo Asset Management.

The move has big implications across the eurozone. The fact that German yields are heading lower suggests that borrowing rates in much of the eurozone could stay negative for longer than many investors once expected.

Returns on German debt are seen as risk-free -- and therefore tightly linked to where the ECB sets interest rates -- so they act as a benchmark for the region, helping determine borrowing costs for governments, corporations and households.

In the U.S., borrowing costs have been moving consistently higher since at least mid-2016 as the Fed signaled that it would start consistently tightening policy.

For some investors, rising German bond yields suggest that the period of global synchronized growth that buoyed confidence at the beginning of the year may be waning. Recent data points to a robust U.S. economy, but indicators in the eurozone have mainly disappointed forecasts.

U.S. consumer-price inflation excluding food and energy has edged up to near the Fed's 2% target. In the eurozone, this measure of inflation has remained subdued, flattening at 1.4% for June.

That will make the ECB less eager to withdraw stimulus, some investors say.

"The Fed is the only central bank with a willingness to normalize policy right now," said Ryan Myerberg, fund manager at Janus Henderson Investors.

Last month, ECB President Mario Draghi confirmed that the central bank's massive program of bond buying would end this December. But he also pledged to leave rates at their current minus-0.4% level through at least next summer. Derivatives markets show that market expectations of a rate increase have now been pushed back from September 2019 to December 2019.

Eurozone bonds rallied in response, suggesting that investors no longer see the end of bond buying as heralding rate rises.

ECB officials also have highlighted that they will continue to reinvest the proceeds of the EUR4.5 trillion ($5.24 trillion) worth of assets they have amassed. Reuters reported last week that the ECB will concentrate those reinvestments on longer-dated bonds, the maturity that is currently rallying the most.

The ECB declined to comment.

"Next year alone, there will be almost EUR200 billion of ECB cash that will need to find a home, 85% of which is maturing government bonds," said Mike Riddell, fixed-income fund manager at Allianz Global Investors. "So it is hard for us to see eurozone government-bond yields selling off aggressively from here, if anything quite the opposite."

According to HSBC analysts, the premium that investors require to hold longer-term instead of shorter-term debt is higher in the eurozone than in the U.S., suggesting that there is still some room for long-term yields to sink further.

Also, the gulf between rising U.S. interest rates and negative rates in Europe and Japan means that a common technique of using currency forwards to hedge foreign-exchange risk is very costly for foreign investors who buy Treasurys. But it provides an extra return for those buying in Europe, bolstering demand.

Bunds may also be benefiting from haven demand, as the U.S. and China spar over trade and political risk has risen in Italy and Germany.

"You've got increased saber rattling and that's a global risk factor with direct impact to Europe, which has more domestic issues," said Mr. Myerberg.

--Tom Fairless contributed to this article.

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