Where German bonds lead the world follows

The normally staid market for German government bonds has been rather exciting of late. It has spent time in highly unusual places, moved in an unprecedented manner and, in the process, is now a major determinant of yields elsewhere, including in the usually autonomous land of US Treasuries.

Crowning an impressive multiyear compression, 10-year German Bund yields reached a record low of 0.05 per cent on April 17. Many of its peers on the German sovereign yield curve, including up to the nine-year maturity point (and even a few corporate ones), were trading at negative nominal interest rates - that is, investors were willing to pay to lend money to the bond issuers. And, with €3tn of the stock of outstanding European debt trading at negative nominal yields, a decent part of informed expert opinion judged that it was only a matter of time until this huge anomaly spread even further.

Five familiar factors had driven this historic yield compression: depressed economic growth; "lowflation" that threatened to morph into deflation; the resurfacing of worries about a disorderly Greek exit from the eurozone; a sizeable programme of asset purchases by the European Central Bank; and a regulated investment community that worried about the implications of a liability mismatch at ever declining yields. All this was temporarily boosted by investors and hedge funds that had been short bonds and needed to cover to limit losses.

The lower the German yield ventured, the greater the pressure for its US counterpart to follow suit. And it did in direction, though not to such a low destination. But like all major moves fuelled by a combination of cyclical, secular and structural issues, the risk of an overshoot was material. It was further fuelled by the notion wrongly embraced by quite a few market participants that the ECB could not just influence but also determine market rates for bonds throughout the yield curve (and well beyond the immediate reach of its policy rate).

Of course, there is a limit to how low yields can go without triggering investor resistance, especially when quite a few go negative. This limit was reached a few weeks ago and is now being corrected as part of a more general market reawakening that is differentiating among yields that had converged excessively, including those for peripheral European bonds.

However, the recent market correction is unlikely to translate into a snap-back that will see 10-year Bund yields surge well above 1 per cent or US Treasuries well above 3 per cent. Instead, they will remain low in historical terms, but not ridiculously so; and German Bunds will continue to be the sovereign debt market from which other sovereign bond markets take their cue.

Global growth and inflation prospects, while not as dire as a few months ago, are far from robust. Notwithstanding the slow and careful decoupling of US Federal Reserve policy, the central bank community as a whole remains ultra-loose, with the likelihood of further stimulus in the months ahead in Europe and China and, with it, a further decline in the supply of "safe assets".

Overvaluation concerns that also extend to global equity markets constrain the flow of funds that might otherwise occur out of low-yielding bonds and into equities. The Greek situation will not be resolved any time soon and, on current trends, is as likely to culminate in a messy accident as just continue to muddle along. And the geopolitical context is far from stable, particularly with the Minsk II ceasefire under growing pressure in Ukraine.

Rather than a full normalisation process driven by a global economy that is regaining a robust economic footing and stronger financial stability, the markets for high quality government bonds will still be littered for a while with securities that have anomalous (though less crazy) yields.

At the margin, this may help stimulate economic activity. But this would come at the cost of reinforcing structural forces that are fundamentally undermining the provision of long-term financial services (such as life insurance and pensions), changing the nature of banking, and still enticing investors to make decisions based on a relative rather than an absolute evaluation - that is to choose the least absurdly rich asset even if it is not a fundamentally well anchored one.

Mohamed El-Erian is chief economic adviser to Allianz and chair of President Barack Obama's Global Development Council

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