The case against bunds

It is perhaps ironic that, as a result of the massive expansion of lending to the Euro System’s TARGET mechanism and its involvement in the ECB’s support operations for peripheral bond markets, the once
conservative German Bundesbank now finds fully 65% or perhaps more of its assets consisting of claims on peripheral banks or governments. Moreover, over the last three months, the Bundesbank has experienced an annualised rate of growth of some 120% in its balance sheet and we can only assume that in time the rate of reserve money growth within its domestic banking system will reach similar proportions. These are remarkably ‘un-German’ events and the German state now has close to three quarters of a trillion euros now riding on the euro Project.

Only five years ago, 25% of the Bundesbank’s assets were accounted for by gold and FOREX and 60% were claims on German domestic banks, and at an extremely broad level, the implicit compromising of the
Bundesbank’s balance sheet through its actions to support the Euro must reduce its credibility and reputation as a hard money authority, and this could reasonably lead to a de-rating of Bunds over the long term.

Moreover, by apparently providing an offsetting officially-sponsored capital inflow for the periphery, the Bundesbank is implicitly lessening the deflationary pressure on these balance of payments deficit countries. However, if these countries do not deflate as is notionally intended by the ECB, then the re-establishment of a long-term competitive equilibrium position within Euroland will require Germany to experience a notably higher trend rate of inflation, which we would also argue as being a negative factor for Bunds. We would suggest that in order to re-establish competitiveness in the periphery, German inflation would have to be 200-300bps above that of the periphery for a significant period of time, which suggests the potential for an average rate of inflation in Germany over the next five to ten years of perhaps four percent. Such a rate would be two and a half times the average rate experienced 1995 – 2010 and clearly this would represent a problem for Bund prices.

If the euro were to break apart, however, then we suspect that the supply of Bunds might leap. The authorities might easily face a bill of €150bn to recapitalise both the Bundesbank and the commercial banks, while the real economy might also need some fiscal assistance as the new currency soared. This supply pressure that this would create in the Bund market could easily match that created by the 2009-2010 fiscal easing.

Finally, we would note that the euro crisis has been an extraordinarily positive factor for Bunds.

According to the German BoP data, foreign purchases of Bunds have been running at a €80bn rate, roughly twice that which existed prior to the Crisis. Moreover, it is also clear that perhaps as much as a third of the foreign ‘flight capital’ from the periphery that flowed into German domestic banks may have subsequently been placed by the banks within the Bund Markets. On a simple ‘back of the envelope basis’, the uncertainty over the fate of the Euro seems to have resulted in €200bn increase in direct and
indirect Bund holdings by foreigners. On top of this amount, they may also have been an increased demand for Bunds for use as collateral given the decline in the number of ‘alternatives’ now available to financial sector borrowers in the collateralised credit markets.

Once the euro crisis is resolved one way or another, presumably either the ‘new DEM’ will have soared, thereby removing much of the rationale to hold Bunds’, or the risk of holding money in the periphery will
have declined following a solution to the crisis and money will begin flowing back to these higher yielding areas. Either way, we may wonder if once the crisis is resolved, several hundred billion of flight capital may ultimately seek to leave the Bund market at a time in which either the German budget deficit is expanding (after a EUR breakdown) or German inflation is rising following a successful euro rescue. It therefore seems to us that in the run up to the euro breaking or being rescued, Bunds may continue to perform well but once clarity returns to the situation, Bund prices should fall, if not in absolute terms (which we think is probable) then at least relative to the periphery on a currency hedged basis.

So much for government bonds being low risk.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla