Bond Panic Ignores ECB Rally Prophesied by Top Danish Fund

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Danish Kroner As Allure Lost on Denmark's Bond Sales
Mixed denominations of Danish kroner currency notes are seen in this arranged photograph in London, U.K., on Friday, July 20, 2012. Demand for Danish kroner that's sent benchmark interest rates below zero has failed to spur corporate bond sales, as issuers seek more developed markets such as Norway to attract investors. Photographer: Chris Ratcliffe/Bloomberg via Getty Images

The biggest commercial pension fund in Denmark, PFA A/S, plans to ride out a bond-market rout it’s betting will soon be ended by quantitative easing.

“We really believe that demand from central banks will eventually stabilize the bond market again,” Henrik Henriksen, chief investment strategist at PFA in Copenhagen, which oversees about $83 billion in assets, said in a phone interview. He estimates that will happen “probably some time during the summer.”

Investors in European government bonds started questioning the sustainability of ultra low, and even negative, yields at the end of last month. Since trading at a low of about 0.08 percent on April 20, the yield on Germany’s benchmark 10-year bond jumped to about 0.7 percent earlier this week. The five-year German yield, which was negative until the end of April, traded at about 0.1 percent on Tuesday.

The sell-off that triggered those market moves followed a 40 percent rebound in crude oil since mid-March that promises to rekindle inflation and erode fixed-income returns.

“Inflation is coming back,” Henriksen said. “Higher energy prices and oil prices will impact inflation for the rest of the year and that’s shifting market attention to focus on inflation.” PFA has added to its holdings of index-linked bonds to avoid losing money on inflation, Henriksen said.

But the main driver of debt prices in Europe remains the specter of continued bond purchases from the European Central Bank, according to Henriksen.

European bonds rebounded on Wednesday with the yield on Germany’s 10-year benchmark note dropping 5 basis point to 0.63 percent. Spain’s 10-year yield fell 10 basis points to 1.7 percent.

Bond Liquidity

PFA is betting a sell-off in bond markets won’t continue “because the ECB’s QE program is simply too big,” Henriksen said. He also sees supply constraints that will drive prices higher. “You have to remember that European issuance will be limited due to declining budget deficits. The number of bonds available to the market will shrink month by month.”

But the dwindling supply and the lack of debt-market liquidity it’s creating are also adding to risks associated with holding on to bonds.

“Liquidity has been pretty poor in the euro-denominated bond market, in part because market makers and banks hold fewer bonds than they used to in the past,” Henriksen said. “The development is amplifying the market swings we’re seeing.”

Losing Value

In Denmark, where PFA is based, a lack of liquidity was probably why the central bank rejected all bids at a Treasury bill auction this week, according to Henriksen. The development marks a turnaround after Denmark struggled to fight back a capital influx earlier in the year that had threatened to destabilize its euro peg.

“There was no demand for those bills in the market,” Henriksen said. The result shouldn’t cause concern for now because Denmark “is well funded and that probably makes them more inclined to wait for the most attractive bids,” he said.

Denmark suspended government bond auctions in January to fend off speculators. But with markets now turning, the treasury will soon be under pressure to rethink that move, according to Danske Bank A/S.

The combined effect of negative central bank rates and scheduled bond redemptions means the government may see its deposits at the central bank drop below 100 billion kroner ($15 billion) in the fourth quarter, Danske estimates. That would trigger a resumption of issuance, according to the bank.

“The Danish Debt Management Office is also obliged to take into consideration liquidity and the overall functioning of the market for Danish government bonds, which means it could opt to restart issuance earlier,” Jens Naervig Pedersen, a senior analyst at Danske, said in a note. “Importantly, we expect the decision to restart bond sales to be independent of monetary policy as bond issuance is not a monetary policy tool.”

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