German bond rally set to resume with UK referendum approaching

Bloomberg

The surge in demand for sovereign debt that drove yields on German government bonds to record lows this week is poised to resume before the U.K. referendum on EU membership on June 23.
While yields on the Germany’s 10-year bunds halted a three-week decline on Friday, they dropped below zero on June 14 for the first time on record, as polls swung in favor of the camp that supports Britain’s exit from the EU. This spurred investors to opt for the relative safety of debt securities from Germany, Japan, the U.S. and Britain.
“Continued nervousness ahead of the looming EU referendum looks set to ensure investors plump for the safety of bunds,” said Nick Stamenkovic, a bond strategist at broker RIA Capital Markets Ltd. in Edinburgh.
German 10-year bund yields were little changed this week at 0.02 percent as of the 5 p.m. close on Friday in London. This was after a decline of 15 basis points, or 0.15 percentage point, in the previous three weeks. The price of the 0.5 percent security due in February 2026 was 104.64 percent of face value.
The yield tumbled to a record low of minus 0.038 percent this week, while that on shorter-dated German bonds also touched all-time lows. The U.K.’s referendum campaign was suspended on June 16 after the murder of lawmaker Jo Cox. The drop in yields has revived talk about the European Central Bank likely facing constraints in its bond-purchase program, which is set to run until March 2017 at a pace of about €80bn ($90 billion) per month.

Scarcity Fears
“Ongoing concerns about the global economy and the shortage of euro-area sovereign bonds point to bunds remaining well-underpinned near-term,” RIA Capital’s Stamenkovic said.
A further decrease in yields could see a larger proportion of bonds fall below the central bank’s minus 0.4 percent deposit rate, which acts as a floor for the purchase program, thus deeming them ineligible for its stimulus plan. Of $6.4 trillion of euro-area government debt in the Bloomberg Eurozone Sovereign Bond Index, $1.25 trillion have yields below the deposit rate.
“With yields where they are now, the ECB won’t be able to buy until March next year,” said Kim Lubbers, a fixed-income portfolio manager at Kempen Capital Management in Amsterdam, which manages about €44 bn in assets.

Inflation Miss
In an attempt to shore up the region’s faltering economy and revive inflationary pressures the ECB cut its deposit rate, extended and expanded its stimulus plan this year and started the purchase of corporate bonds in June. Yet, inflation has been at zero or below for 10 of the past 18 months.
“The ECB needs to solve this,” Kempen’s Lubbers said. “It needs to say ‘we’re going to buy below minus 0.4 percent’, or they need to relax the capital constraints. I think they’ll see what happens after the Brexit vote and probably do something.”