* German yields dragged down by weak economy, easy policy
* German funding costs may avoid new lows on lower euro risk
* Euro zone yield convergence not based on fundamentals
By Ana Nicolaci da Costa
LONDON, April 12 German bond yields, close to
their lowest since the European Central Bank pledged to save the
euro, may not fall much further as long as investors keep faith
with the "whatever it takes" promise.
German borrowing costs hit their lowest last week since ECB
President Mario Draghi vowed to protect the euro in July, but
analysts say this time the doomsday scenario of a euro break-up
is not the main driver and this should set a floor for yields.
That is because Draghi's speech was followed up by a pledge,
so far untested, to buy the bonds of struggling sovereigns,
significantly reducing the risk of the euro collapsing.
"Back in July last year, when we were pricing these very low
German yields, that was against an existential risk to the
euro," Thushka Maharaj, interest rate strategist at Credit
"Now they are a function of the weak (euro zone) data, the
expansion of bond-purchases we are seeing globally, more notably
in Japan, and changes to regulation which require more
collateral and keeps demand for high quality assets high."
Investors favour euro zone benchmark Germany's triple-A
rated and liquid debt in times of market or economic stress.
A sluggish U.S. economic recovery was also underpinning
demand for safe debt, analysts said.
Ten-year German yields hit their lowest since
July 24 at 1.199 percent last Friday after the ECB said it was
ready to act to revive growth and after the Bank of Japan
announced a stimulus plan involving massive bond purchases.
The move spurred speculation Japanese investors would dump
local bonds in favour of euro zone debt.
While higher-yielding but low risk debt from France, the
Netherlands, Austria and Belgium in particular were expected to
benefit, German bonds could also see inflows from Japan.
However, 10-year yields bounced off last Friday's
eight-month low and were last at 1.27 percent.
Patrick Jacq, rate strategist at BNP Paribas, does not
expect German 10-year yields to match or break below record lows
of 1.126 percent hit in July of last year.
At that time, yields on bonds from highly-indebted countries
such as Spain and Italy were approaching levels seen as
unsustainable and investors sought shelter in low-risk Germany.
"Along with the decline in German yields we have a
tightening in (peripheral) spreads which means that it is not
driven by flight to quality. So it doesn't make sense to see
ten-year yields in Germany falling (to) levels we were at last
year or even lower," Jacq said.
He recommends selling Bunds when yields fall below 1.30
percent, also because the bonds would look less attractive than
those of other relatively safe euro zone countries.
"When you look at the level of yield in Germany and when you
look at the level of volatility which I would say is almost
similar in Germany, France, Belgium, and Austria, you have a
risk return environment which is not favourable in Germany."
Some analysts said the relative calm in financial markets
was precarious because it is based on a promise of ECB action
and sentiment could quickly turn should investors begin to
question the central bank's commitment.
In that case, Bund yields could break to new lows as
investors seek refuge in safe-haven assets.
At the same time, they said the recent narrowing in yield
differentials within the euro zone, which in some circumstances
might suggest investors were not discriminating between risks
associated with different countries' debt, was exaggerated.
That is because it had mainly been driven by a fall in the
funding costs of Spain and Italy, supported by the ECB backstop,
rather than by a rise in German yields, suggesting investors
"The fact there is almost no movement from Germany and a
huge movement in peripherals is indicative to us of this
convergence for the wrong reason," Lyn Graham-Taylor, fixed
income strategist, at Rabobank said.
Spanish and Italian yields have
fallen more than 200 basis points since Draghi's promise to
protect the euro last year, while German borrowing costs have
barely budged over the same period.
Even though a gloomy economic outlook is likely to keep
German yields relatively low, analysts say as long as investors
believe in the ECB financial backstop, they will be willing to
take risk, limiting the scope for a fall in German yields.
"The last time they were below (the Friday low) was when
Greece was on the brink of default and it looked as though a
country could leave the euro," said Carl Norrey, head of
European rates securities at JPMorgan in London.
"Since then, we've had the OMT (ECB bond-buying program) and
a number of other things which have given the confidence that
the ECB is determined to keep the euro zone intact. As such,
it's hard for investors to get excited about being long Bunds."