A new era of short bets against German bonds is beginning

Brussels

THERE'S an unwritten rule in global bond markets: never short Germany.

But when Europe's safest asset is in the midst of a retreat that threatens to push yields on bunds above 0 per cent for the first time in more than two years, a paradigm shift may be underway.

Toronto-Dominion Bank was forced to close its recommendation for investors to buy German bonds last week, after yields climbed above their stop-loss level. NatWest Markets are calling for investors to sell bunds, hailing the end of the "supercycle" that has seen the securities rally for the best part of two decades. Goldman Sachs Group and ING Groep are among banks who see yields rising to 0 per cent by the end of the year.

"The accelerating selloff in Germany is probably the defining feature of the market right now," said Richard McGuire, head of rates strategy at Rabobank International.

As the vaccine rollout gathers pace across the region, bets are on for a remarkable economic comeback - and an accompanying spike in inflation. That, together with the prospect of reduced bond buying by the European central bank, has eroded the haven appeal of bunds, while simultaneously threatening to sap appetite for high-yielding notes of debt-loaded nations like Italy.

"The two cannot co-exist happily with each other," Mr McGuire said. "There is a tension between bund yields rising as the market prices out ECB support and, at the same time, putting upward pressure on peripheral borrowing costs."

Long-term investors have had to pay up for the privilege of holding German debt, which is seen as some of the safest that money can buy - a reflection of its scarcity and the ECB's extraordinary package of stimulus measures. That process was turbo-charged by the pandemic, pushing 10-year yields down to within touching distance of minus 1 per cent last year.

But expectations are growing that the ECB could start tapering its pandemic programme this summer, potentially removing a key pillar of support, even as borrowing needs remain high. While quantitative easing helped cover the growing deficits of Italy and Spain during the pandemic so far, that might not be the case this year, HSBC Holdings said.

There's also a political dimension to the rising yields. The growing strength of Germany's Green Party is feeding through into bets that elections later this year could trigger a break with the nation's traditional fiscal caution.

Germany has historically maintained a so-called debt brake over the years, keeping the budget balanced and bond issuance limited.

The 30-year swap spread - which is sensitive to expectations of bond supply - narrowed last week by the most in more than a year as investors prepare for increased spending and less monetary support.

"It's a quiet revolution," wrote Giles Gale, head of European rates strategy at NatWest. Although the ECB "are buying at a stonking pace, they aren't soaking up all the gross supply". While US Treasuries have been caught in the reflation frenzy since the start of February, the fact that yields are catching up in Germany - a bastion of tepid price increases - is sending ripples across markets.

The world's stock of negative-yielding investment grade debt - of which Europe made up the bulk - has fallen to around US$12 trillion, the lowest level since June last year. As a share of outstanding debt, it's now below 20 per cent, compared with more than 30 per cent at its peak in 2019.

In equities, investors are rotating out of more expensive growth stocks and into cheaper value securities, according to Kasper Elmgreen, head of equities at Amundi.

And European corporate bonds are feeling the effects too. The latest jump in yields has pushed about 80 per cent of high-grade notes sold this year below their issue price, based on data compiled by Bloomberg. That's up from earlier this month when the share of post-issuance losers stood at just under 50 per cent.

Traders have accumulated the largest short position in junk bonds since 2008 and high-grade short-selling has risen to its highest level since early 2014.

The pickup in reflation bets in markets matches the outlook among economists surveyed by Bloomberg. The latest data show them raising their forecasts for consumer-price growth in the euro to 2.3 per cent in the fourth quarter from 2.2 per cent previously, and clearly above the ECB's medium-term target of just under 2 per cent.

Positive bund yields would also have a psychological impact.

In BofA Global Research's latest European credit investor survey, 15 per cent of respondents said the rally in corporate bonds will be done when 10-year German yields turn positive, making it the second most-cited bearish trigger after central bank tapering.

"Everyone is at peak inflation panic," said Charles Diebel, a money manager at Mediolanum. "It's psychologically important." BLOOMBERG