Now that much of the Bund yield curve has broken through zero, can Bund yields go even lower? Our sense is that the technical backdrop means that yields will hold these levels, and may go a little lower. However, to move decisively lower, they would need further European Central Bank (ECB) rate cuts and/or another bout of financial market turbulence. In that case, analyses of previous bouts of instability suggest that Bund yields could go as low as -0.5% to -1%. Outside of that, we think the most likely course is a grind lower in yield for longer maturities, rather than more negative yields in shorter bonds.
What is clear is that the -0.20% floor on deposits at the ECB, persistent Bund buying by the ECB and a dearth of high quality collateral provides strong technical support for current levels.
The deposit facility interest rate sets the floor for money market yields, in theory, because the ECB’s demand for money from banks is unlimited at this rate. This assumes central bank reserves, defined as money commercial banks deposit at the ECB, are perfect substitutes for other money market instruments. In practice they are not.
Non-bank financial agents cannot directly access the ECB’s deposit facility, and risk-averse ones are willing to pay even lower negative interest rates than those charged by the ECB. New regulation, such as the liquidity coverage ratio, mandates banks hold high quality liquid assets (HQLA), like AAA-rated government bonds. These market segmentation and regulation factors may be creating price-insensitive demand for Bunds and repurchase agreements using them as collateral.
Accounting and capital regulation rules dis-incentivise insurance companies to sell government bonds to the ECB, owing to a lack of alternatives. And Germany’s budget surplus means there are fewer new bonds available.
Mix negative policy interest rates, a premium for HQLA demand, limited supply and increased buying from ECB quantitative easing, and it is not implausible that the entire Bund yield curve (see chart) declines to zero – or even dips below.