Ten-year Bund yields completed a secular journey from more than 10% in early 1981 to virtually 0% in early 2015. Having reached rock-bottom levels in late April 2015, yields briefly rose above 1% by mid-June, only to settle back down to 0.7% in July. Volatility, in other words, picked up.
At PIMCO, we see five factors that are likely contributors to the current bout of Bund market volatility.
- Perceptions of deflation risk: The recent rise in Bund yields suggests deflation risks have been truncated. The European Central Bank (ECB) made it clear it is committed to its quantitative easing (QE) program until September 2016, no matter what. But other than a small pickup in eurozone inflation and oil prices recently, there is little evidence to justify such a large perceived decline in deflation risks.
- U.S. economic and dollar strength: The U.S. Federal Reserve remains on track to raise rates later this year, and Bunds cannot decouple entirely from the U.S. In addition, emerging market central banks have bought their local currencies and sold foreign exchange reserves in order to maintain stable exchange rates against the strengthening U.S. dollar. It is plausible they sold lower-yielding European government bonds in the process.
- Increased market sensitivity: The structure of the bond market has changed. Recent banking regulation has obliged banks to raise capital ratios, curtailing the amount of bonds held for market-making. With banks less willing and capable of market-making, modest quantities of bond sales or purchases can lead to outsized price movements.
- ECB QE: QE may be contributing to higher volatility. QE removes the most liquid securities from the market, forcing investors who need to adjust portfolios to do so using the smaller float of government bonds remaining, or to utilize other securities – predominately corporate bonds – with less liquidity. The ECB also provides only partial details on its bond purchases and this limited transparency may be contributing to volatility. In addition, the Bundesbank, which purchases most of the Bunds in the ECB’s QE program, has shown a preference for shorter-maturity bonds, a signal that longer-maturity bonds do not enjoy full QE support.
- Political uncertainty: Uncertainty about the ultimate outcome of Greece’s eurozone membership added to the seesaw movement in Bund yields.
In our view, Bund yields are caught between the support of continued ECB QE, limited fundamental value and rising U.S. yields. While retesting the lows cannot be ruled out, this would need a material increase in deflationary risks, which looks unlikely. Many of the factors driving recent Bund volatility are still active; however, ultimately it takes stronger economic growth and higher rates of inflation to drive yields sustainably higher, neither of which looks likely any time soon. In the meantime, however, continue to expect heightened Bund yield volatility.