Since the launch of PSPP (i.e. ECB QE) on March 9, quite a bit of attention has been paid to German Bunds. Under the program, national NCBs’ share of monthly purchases is based on the ECB’s capital key and as it turns out, it’s going to quite difficult (if not impossible) for Germany to source enough purchasable assets given projected supply and Q€’s structural limitations. This has led to collapsing yields which have in turn forced the ECB and the Bundesbank to look further out in terms of maturities in order to avoid the -0.20% yield floor causing an epic flattening of the Bund curve as everything converges on the depo rate.
For all the visual learners out there, here’s a table showing the shortage of purchasable assets in Germany…
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...and as central bank purchases move further out…
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...the curve flattens…
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...and GC rates collapse…
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This dynamic recently prompted David Einhorn to ask Mario Draghi [17] “what he thinks a bubble in sovereign debt might look like that isn’t already evident,” and led Bill Gross to call [18] Bunds the “short of a lifetime.” So with only six weeks (or one Graccident) to go until Bund purchases are forced out to 7-year maturities, and with traders warning that nearly every piece of PSPP-eligible German government paper will eventually trade special in repo despite the ECB’s feeble attempt to remedy the situation via its Securities Lending Program, the world wants to know: “when do I sell Bunds?” Here’s Citi with more:
Our forecast of a negative 10y Bund yield (-0.05%) mostly elicits little more than a resigned fatalism that the core bond markets are trading on technicals and not fundamentals, but the question perhaps for business survival is when do Bunds sell-off, and how can that be positioned?
Tactical selling opportunities
a. Nudging global recovery/inflation higher and global policy stimulus. There may currently be low correlation to economic indicators, but we do not buy the idea that global growth/inflation is completely irrelevant. For instance, on our framework on global disinflation trends, led by China, it is tactically important that the PBOC cut the RRR by 100bp this week – potentially moderating the export of deflation (see Figure 10).
b. Greece is fixed. There will be a component of the rally that is premised on Greek caution or hedges. We expect Greek economic outcomes to become clearer in June and it may be tough to avoid capital controls, but once Greece is resolved, our sense is that Periphery rallies hard and Bunds weaken short term. That resolution includes Grexit as we see little short-term contagion in markets and investors are instead left to mull over longer implications.
c. ECB adapts QE to scarcity by fudging the capital key. Why do we pick -5bp as a yield target in 10yr Bunds, and not -20bp? There is no model but at this level we expect a conversation at the ECB council that the execution of the programme for core countries is looking more hazardous. The ECB cannot taper given the hit to credibility and what is likely to prove a material move higher in EUR FX (witness the CHF as the SNB stepped back from the currency war) and so the options are to add more asset classes (e.g. German state debt) or make the adherence to the capital key more fuzzy, where the Bundesbank still buys German bonds but shortfalls in quotas are made good by NCBs that do not face supply constraints in their own debt markets. That should be positive for periphery and a tactical sell signal on Bunds.
And as for where 10-year bunds (Bill Gross’ “Big Short”) should trade after a proper reversal…
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Figure 15 shows the result of an economic regression that also includes 5y rates as an explanatory variable...
A correction of the excessive flattening – which accelerated in Q4-14 as ECB QE expectations built up, would put 10y Bund back to 0.75%.
And if all of the above is too much to process, here's our assessment in a nutshell:
What this means is that far from being the short of a lifetime right now, Bunds are in fact quite the opposite, and their progression to the hard -0.20% floor across the curve is just a matter of time before everyone decides to frontrun the ECB's purchases over the next year. Because if the ECB will have no choice but to buy even more Bunds from the private market, then the sellers can demand any prices for these Bunds, up to and including the ECB's hard (for now) floor of -0.20%!
And yes, once the entire German curve is trading at -0.20% then Bill Gross will be spot on, and Bunds will indeed be the short of a lifetime.
