Wednesday, November 23, 2011

Are German bunds now a risk asset?

This morning, the German finance ministry’s auction of 10-year notes was substantially undersubscribed, forcing the Bundesbank to buy 35% of the sale, and resulting in a 15 bp rise in yield to 2.06% (compared with 1.90% for comparable-maturity Treasuries).

Until now, German bunds have been the risk-free benchmark for the eurozone, against which other issuers’ credit spreads are calculated. It would now appear that if the Treasury were to offer benchmark maturities in euros, they would trade through bunds. In other words, there now appears to be some sort of risk premium being added to bund yields.

Markets don’t give reasons for their decisions, and therefore there is no way of knowing why this happened. It certainly hadn’t been predicted. I can come up with a few possible reasons:
1. Bond investors performing top-down sector analysis have decided to reduce their exposure to Europe in general and the eurozone in particular*.
2. Investors recognize that there is a risk that the ECB will start printing money (for various reasons) producing a change in inflationary expectations.
3. There is a risk that Germany will be forced to backstop other eurozone sovereign credits, thus threatening Germany’s AAA rating.
4. A collapse of the eurozone could plunge Germany into a recession which would create fiscal pressures.
5. Speculators who have been long bunds and short peripherals may have decided to close out, thus increasing the supply of bunds on offer (although this seems pretty far fetched).

Whatever the reasons, the signal that it sends is a very bearish one. If the markets start demanding a risk premium for bunds, then premia across the board must rise further. Also, this event may strengthen the hand of those arguing against Germany risking its AAA to help the eurozone.

My conclusion would be that the eurozone is now in extremis barring something major coming out of the ECB or Berlin.
*In this evening's FT: A senior trader at a US bank said: “We are now seeing funds and clients wanting to get out of anything that is denominated in euros and that includes Bunds because they don’t know what will happen to monetary union." 

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