No limit to ECB support, but a limit to the rise in Bund yields
Since reaching an all-time low of -0.87% on 9 March, the 10-year Bund yield has moved up, standing at -0.44% on 12 June. The rise has not been linear, however, with a lack of market liquidity meaning yields fluctuated wildly in March before fiscal stimulus announcements proved a catalyst for inflation expectations, leading to a rebound in yields starting in May.
Indeed, the covid-19 outbreak has convinced the German government to open the spending tap, with the announcement of two sizeable stimulus packages. In early June, the government announced a sizable €130bn package (equivalent to 3.8% of GDP in 2019) stretched over 2020 and 2021 to support consumers and corporates. The covid-19 crisis has also prompted a change of approach to Europe, with the Germans seeming willing to forego previous taboos on common debt issuance and transfers across countries.
German net debt issuance is expected to rise strongly, by up to EUR200bn over the next 12 months. Although we expect the covid-19-led recession to be deflationary in the short term, over the longer term such measures could help revive inflation expectations. Still, these expectations could remain low by historical standards,
Taking into consideration the upward pressure on inflation expectations stemming from fiscal expansion and reduced ECB purchases at the long-end in its PEPP programme, we now expect the 10-year Bund yield to remain closer to -0.3%, compared to our previous expectations of around -0.8% over the next few months. We remain comfortable with our central scenario of -0.4% for the 10-year Bund yield at the end of 2020 as Bunds continue to be torn between higher inflation expectations and ECB buying.
However, we acknowledge that the massive fiscal response in Germany and Europe at large increases from 10% to 25% the probability of our positive scenario, which foresees the 10-year yield moving back to zero by year’s end. We also see the Bund’s safe-haven status remaining entrenched, although there is limited room for a sharp fall in yields in the case of renewed turmoil. For this reason, plus the persistence of negative yields, we remain underweight core euro sovereign bonds.