If you follow financial markets then you’re likely aware that one of the biggest stories of the week has been the great German Bund route as everyone’s new favorite short has sold-off hard on what HSBC calls a “cascade of small events [which has] created a large splash in a structurally ever-thinner mkt, similar to UST flash crash of Oct. 15.” Amid the cacophony of explanations emanating from every credit and rates strategist on Wall Street, BNP is out with a simple suggestion: it’s all about the waxing and waning of supply.
Despite the recent sharp sell-off of the past two weeks, Bund yields remain well below any economic value: on our model (based on US 10-year yields and German economic data), fair value currently lies somewhere above 1% for the 10-year Bund yield…
Therefore the past two weeks’ sell-off must be recognised as primarily reflecting changing supply/demand dynamics, as supply net of quantitative easing (QE) swings from EUR -46bn in April to EUR +45bn in May…
Yields are off from their recent lows, except at the front end. The 10y Bund yield is, at 0.28%, roughly 20bp above its trough. Upward pressure on yields has been more pronounced in core markets than in peripherals and, over the past fortnight, the Bund has been the worst performer – the sell-off took place in risk-on mode. 10y BTP/Bund and Bono/Bund spreads tightened 20-25bp during this period.
The FOMC statement and positive developments in negotiations between Greece and its creditors could weigh further on core EGBs over the weeks ahead, but these factors are still uncertain. However, the imbalance between net supply and demand is a significant known factor, and as such the shift from EUR -46.4bn to more than EUR +45bn in May is likely to reinforce upward pressure, especially on real yields (Chart 1). But the 10y Bund yield at 0.25% is still only half what it was at the beginning of the year. Nominal yields and breakeven inflation would have to rise a lot more before we could say that the improving fundamentals are being expressed in market pricing. The 10y Bund to rise closer to the 0.35/0.38% area expected within the next couple of weeks (around 156.20/40 on the Bund future) has occurred today and quickly reversed. We keep the short duration exposure we recommended last week as the market could hover close to today’s lows in the near-term.
So, exactly what we said earlier today: "...speaking of positioning, perhaps the biggest drive of the Bund weakness as we enter May is that German net flows turn from sharply negative to modestly positive, suggesting the technical pressure will be far less."
And when it comes to supply, have a look at the following, which shows projected net issuance by country (including PSPP purchases).
Since this is no secret, it seems to us that what a rational actor would do in this situation is simply buy where net supply is projected to be the most negative. That way, when the respective NCB buyers come calling in a desperate attempt to meet their monthly purchase targets under the capital key, holders will be able to charge as much as they want right up to the depo rate floor. Or, as we put it last week when Bill Gross trumpted Bunds as the next big short:
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%!