GERMAN BONDS SEND WORRYING SIGNAL / THE WALL STREET JOURNAL

April 29, 2013, 12:04 p.m. ET

German Bonds Send Worrying Signal

By RICHARD BARLEY

 

 

 

From one perspective, the euro-zone crisis is firmly in abeyance: Spanish and Italian bond yields are at their lowest level since late 2010, racking up another big rally Monday after Italy finally formed a government. But another crisis indicator is flashing red: German 10-year bond yields also fell Monday, to 1.19%, their lowest since July 2012, when Spain was at risk of losing market access and investors were fretting about a euro-zone breakup. What can explain this?

German bunds sold off sharply in January, driven by a global pickup in risk appetite. But since late February, yields have steadily fallen; in the past two weeks, Germany has sold 10- and 30-year bonds at the lowest yields on record to decent demand. That has occurred even as talk of a "search for yield" has become widespread: Corporate "junk" bond issuance has been on a tear, and investors have even snapped up sovereign bonds from Rwanda.

Germany has a number of structural supports. It is a rarity among developed-market governments in running a budget surplus, which came in at 0.2% of GDP in 2012. That means very low German net bond issuance: For investors simply to maintain their exposure to Germany, they have to keep rolling over their holdings by buying at auctions. After steep ratings downgrades for southern Europe, some of the money that has flowed into Germany won't flow back again, either. Spanish and Italian bonds are now more about credit risk tan interest-rate risk.

But more important is the economic data. The euro-zone remains mired in recession, and even Germany's economic engine is sputtering.

Global conditions have weakened, with questions being asked of the U.S. recovery. Meanwhile, German inflation has slumped to just 1.1% on a European Union harmonized basis. The case for a bond-friendly European Central Bank rate cut Thursday is strong, even if on its own it may have little impact on the euro-zone economy.

The tension is clear: If the euro-zone economy picks up again, German bonds will look vulnerable. But if it continues to worsen, then risky assets could take a tumble. The jury is out. But when it returns its verdict, one of the two could look badly mispriced.