German bonds measure success of eurozone QE

Northern European government bond markets are not meant to fray global investors' nerves. They should be stable and dull, their role merely to finance some of the world's most advanced and fiscally-prudent economies.

Lately, however, they have been worryingly full of spills and thrills, especially Germany's "Bund" market. The past week has seen big swings in yields on 10-year German debt, which have become important gauges of the success - or otherwise - of eurozone quantitative easing.

As oxymoronic as it sounds, yields on Bundesanleihen, or German "Federal bonds", have become compelling viewing for those concerned whether the latest great central bank experiment with monetary policy is creating serious distortions - or may actually work in pulling the eurozone back from a deflationary slump.

Typically, higher economic growth and inflation expectations push up yields. So rises in Bund yields could be a sign that QE is expected to succeed; US Treasury yields rose when the Federal Reserve launched QE. More turbulence, however, would heighten fears of a disruptive sell-off.

Until early last week, heavy buying by the European Central Bank had pushed yields on 10-year Bunds, which move inversely with prices, ever closer towards zero. Yields on two-year bonds fell below minus 0.2 per cent - the level below which the ECB stops purchases.

But then the seemingly relentless fall in yields came to a sudden stop. Within hours they jumped sharply; at low levels, small absolute changes look like massive swings. On April 22, Bund yields almost doubled from 9 basis points to nearly 17 basis points; traders made black jokes about a "flash crash". This week the volatility has intensified - after stronger eurozone economic data, Bund yields are now four times higher than on April 17.

What happens next will have wide repercussions. Bund yields act as benchmarks, affecting prices across European financial markets. That is not the result of German grandstanding: the Italian and French government bond markets are larger; Germany's Finanzagentur is not housed in a Baroque palace but modern offices on an industrial estate outside Frankfurt. Before the launch of the euro in 1999, French bonds offered better benchmarks, for instance in inflation-linked bonds or futures.

Under Europe's monetary union, however, Bunds have taken over because of their supposed stability. Berlin's relatively low debt levels and reluctance to run fiscal deficits are also bondholder friendly - even if widely blamed for exacerbating eurozone economic woes.

Yet Berlin's budgetary prudence created problems for the ECB's QE programme. In the US and UK, asset purchase programmes were launched when governments were running large deficits. ECB QE was launched when the net supply of Bunds was negative - raising worries the ECB would run out of bonds to buy. As a result, yields may tell us more about QE strains than expectations about economic growth or inflation.

Shortages of Bunds have created tensions in "repo" markets - in which government bonds are used as collateral to borrow cash. The effects could quickly spread into markets more generally. So far, attempts by the ECB to alleviate repo stresses by lending back bonds have not worked - traders complain that securities lending programmes vary between eurozone countries and are too costly.

The causes of the most recent turbulence are unclear. Some think investors had become too fixated on the idea of negative Bund yields and that a correction was inevitable. But better data on eurozone credit conditions and inflation expectations were also a reason for investors to sell Bunds.

The Finanzagentur, meanwhile, dismisses the idea of QE upsetting trading conditions, arguing liquidity in secondary markets remains strong. "We haven't noticed any distortions in the Bund curve," says a spokesman. Others, however, are not so sure. "The reason why you are getting these wild fluctuations is due to liquidity - or rather the lack of it," argues Steven Major, HSBC's head of fixed income research.

Such problems would ease if Bund yields rose further, increasing the pool of assets eligible for the ECB's purchasing programme. The snag is that the adjustment is unlikely to be smooth. Because they fell so far, even small yield rises could create havoc in investors' portfolios. The white knuckle Bund rollercoaster ride may have only just begun.

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