Over the past several months, the German bund has rallied and the euro has fallen. This Great Graphic from Bloomberg illustrates the co-movement. The 10-year bund yield is the white line. It fell from almost 1.5% to nearly zero. During the same time, the euro, depicted by the yellow line, fell from around $1.40 to $1.05.
The correlation is near a record. Over the past hundred sessions the two moved in the same direction about 93% of the time. For most of Q2 14, the correlation was inverse.
The disappointing US economic data had pushed out expectations for the Fed's liftoff, which may have contributed to the dollar's stalling upside momentum. However, it seems that the unwinding of long bunds and short euro positions may have been the impetus behind the break out of the month-long range between $1.05 and $1.1050.
The key question is whether the sell-off in bunds marks the end of the big bull move. In the US experience, bonds often rallied ahead of the implementation of the Fed's QE and retreated as it became operational.
We remain struck by the looming shortage of bunds. Prices distribute that scarcity by rising. The scarcity stems from three sources.
- First, the grand coalition government in Germany is pursuing a balanced budget this year, even though it is still being paid to borrow through four years.
- Second, despite the low costs of debt, Germany will be paying down its debt, which limits the new supply and cuts a little into the old supply. And just at the moment in time when the ECB is buying and regulatory authorities are encouraging banks to strengthen their balance sheets, which has meant more owning more sovereign bonds.
- The third -- and often overlooked -- factor is the widespread use of bunds as collateral. It is true that the ECB makes its supply of bunds available to banks via a securities lending program. However, the cost, 40 bp, is seen by market participants as too high, which discourages its use and thus does not offset the shortage.
Lastly, we note that DBRS is set to review France's credit worthiness. With a negative credit watch, there is some risk of a downgrade. If this is indeed the case, it may increase the demand for bunds and intensify the shortage.