Great Graphic: German Bunds, Inflation Expectations And The Euro

The dramatic sell-off in German bunds caught many investors off guard. The conventional wisdom, for which we too were sympathetic, was that there was going to be a shortage of bunds. 

The Grand Coalition led by Chancellor Merkel is not only committed to a balance budget this year, but it will also retire some debt. These policies limit supply at the same time that the ECB's bond buying program increases demand.  In addition, bunds are used not only for investment but collateral. 

The German 10-year yield fell around 56 bp at the end of last year to about 5 bp in mid-April.  It has since risen sharply. The first leg carried it to about 80 bp into early May. It consolidated for a couple of weeks, and since the start of the month, taken another step up. Today the yield reached almost 1.06%. This is depicted by the yellow line in this Great Graphic created on Bloomberg. From a chart-based perspective, the next target is near 1.25%. 

A key question is why are the bunds selling off. There is much to be said for market positioning and the lack of liquidity.  Long, and even overweight bunds, was a favorite position for real and leveraged fund managers. It also was a defensive position in case of Grexit or worse. The lack of liquidity is often attributed to official action in the form of QE, but also the greater regulatory environment. In addition, we would include technological developments, which have also served to fragment the market. 

There is another factor that few accounts incorporate. Inflation expectations have risen. Inflation in the eurozone has been trending lower. The drop in oil prices was an additional force that weighed on headline inflation, which is what the ECB targets. Indeed, it was precisely risk of deflation that prompted the ECB to announce an asset purchase plan over the objection of Germany, though it has not stopped observers from arguing that Germany drives EMU monetary policy.  

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