What’s next for bund yields?
17th April 2019
Bund yields (and bond yields in general) have defied bond bears for many years, and this year has seen more of the same: in March, 10-year bund yields reached lows of around -0.08%. There seems to be a consensus that Bunds are fundamentally overpriced, and that a 0% level is somehow unnatural. In this blog, I discuss why, in my view, this is not the case – and why the 0% level is not actually very relevant; it’s a barrier that appears real, but is in fact an illusion. I go through a number of different ways to think about this. Finally, now that bund yields are above 0% again, I look at what the future holds for bond yields in Europe.
What’s the “correct” level of bond yield?
Let’s start with a simple model. What should the yield on a 10-year German government bond be? i.e. how much should investors charge a country to borrow money? Let’s start with the price of money, which is just the base rate, currently -0.40%. Of course, this can change. So we can think of the 10-year yield as an average of the base rate over that time. Now, there can also be a risk premium attached, (for example, for the possibility of default) but for Germany, we can assume that is zero.
Now, with bund yields currently at 0.10%, we can see that the market is “pricing in” a number of hikes, and more than you would imagine. To get to an average of 0.10%, when we are currently at -0.40%, means the market must be pricing in higher than 0.10% for a long time. Further down, we look at exactly what is priced in, by looking at OIS (Overnight Index Swap) markets.
Bund yields and euro interest rates aren’t strictly the same
Moreover, the ECB (European Central Bank) deposit rate is for euros, so we can think of that as the average government bond yield across the Eurozone. We should expect that German bond yields, for example, would be below this average, while Greek, Spanish or Italian would be above. That’s exactly what we find – the German bund curve is below the euro swap curve.
Eurozone curves are steep
So far, everything seems fine. So what’s all the fuss about? What is so mispriced? The reason many are confused, is because they compare bund yields to either 0%, or to historical yields. But what we need to compare yields to is the base rate. When we do, everything makes more sense. In fact, Eurozone yield curves are quite steep – that is, 10-year yields are quite high relative to front-end interest rates.
Looking at derivatives
So what exactly is priced in, in terms of ECB rate hikes? Fortunately, products exist that can tell us this precisely: OIS swaps. Here is what they are telling us:
So over the next 10 years, European rates are implying around 1.5% of hikes, and this is reflected in bond yields – which is why the curves are so steep.
So as we already know from bond yields, there is a lot priced in. In other words, if an investor buys a 10-year bond, and these hikes do not materialise, they could earn a handsome return from capital gains, and not just the coupon.
Earning positive return for assets that yield less than 0%…
You may still argue, however, that if an investor buys something that yields less than 0%, they will ultimately lose money. But consider the situation where an investor can borrow at -0.40%, and buys an asset that returns -0.10%: the investor makes a positive return. Now, not every investor can borrow there, but some, including European banks, can.
Borrowing in the currency markets
There is a way, however, where most investors can borrow euros at negative rates – in the FX swap market. For example, a US investor can sell their US dollars for euros today, and at the same time enter the reverse trade in the FX forward market, so as to not take currency risk (these two trades combined are called an FX swap). The forward FX rate reflects the interest rates on both currencies, and hence the US investor has borrowed euros at negative rates. Which is why, if a US investor buys a 10-year bund today, and hedges the FX risk, they will receive a yield of around 2.30%!
Not yet convinced? Let me try one more time:
Instead of buying a 10-year bund, we can do a very similar trade: receive a 5y5y EUR IRS (interest rate swap). This is a 5-year euro interest rate swap, starting in 5 years’ time. The current rate is 1.08%. If an investor enters into this trade, in 5 years’ time, this will simply become a 5-year IRS. What’s the current rate of that? 0.06%. Hence, if an investor enters into this trade today, and nothing changes in terms of base rate (which for the Eurozone, is actually our base case assumption), then the trade would make them 100bps. In the bond world, this is like buying a 5-year bond which rallies by 100bp; they would make a capital gain of 5%.
What happens to European government bond yields in the near future will largely depend on the economic outlook: recent green shoots, especially in China, have improved sentiment. Europe’s links with China (via trade) suggest that European data itself will start to pick up, and indeed, it has started to already.
However, longer term, there is no reason why yields cannot go and stay below 0% for a long time. When the next recession comes, and the prospect for raising interest rates evaporates, that is very likely to be the case: there is plenty of room for bund yields to go lower from here.