Markets

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

For a brief halcyon moment on Thursday the confluence of a political bromance at the center ground of French presidential candidates and charges that a top aide to Marine Le Pen misused public funds produced a sharp contraction to the ever-widening spread between French and German government bonds. Frankfurt's putting the pressure back on, and it's probably going to stay there.

Le Spread Marches Higher
With about two months to go before the French presidential election, a pronounced narrowing isn't in store
Source: Bloomberg

The Bundesbank has finally unfriended quantitative easing. President Jens Weidmann informed us Thursday that he didn't support extending the European Central Bank's Public Sector Purchasing Program in December. And the Bundesbank has made a point of raising provisions for expected losses once the ECB starts raising interest rates. With friends like these, Mario Draghi must be feeling lonely.

To compound the trouble, deep in the plumbing of the financial system, the German central bank seems set on making a bad situation worse. The collateral shortage in the repo market, which Gadfly has already warned about, is getting more acute. The ECB tried to address this, but turns out that it didn't buy itself much time with its Dec. 15 decision to allow national central banks to buy their own government debt as low as minus 70 basis points -- German debt under four years already yields less than that new floor. It looks like German buying at the front end of the yield curve is to blame for pushing 2 year yields towards minus 1 percent, akin to Swiss levels. 

Too Much Cash, Not Enough Assets
Collateral scramble is driving the two-year Schatz benchmark yield to minus 100 basis points
Source: Bloomberg

Compounding the felony is that in the collateral borrowing markets, the Bundesbank only lent out a tiny amount of its bund holdings over year-end in the repo market, yet both it and the ECB hold over a quarter of outstanding German debt. This parsimony does not suggest a central bank that prizes efficiency in transactions. 

It's within the German debt office's gift to ease tight conditions by altering or increasing the supply schedule. A spokeswoman made clear on Thursday that, if there ever were to be a problem with a squeeze in the cheapest-to-deliver security into the 10-year bund futures contract, it would act by issuing more bonds, Reuters reported. She made equally clear that issuance won't increase at the short end to tackle market strains. 

So there is no relief in sight for ever-more-negative yields, not even the attraction of being paid to raise money. Citibank analysts say further new lows in Schatz yields are inevitable as the ECB needs to buy around 80 billion euros of bunds due in one to six years by year-end, so below minus 1 percent is in sight. If this feeds into difficulties in extending QE beyond December, the ECB's backstop for the periphery is going to be tested.

The low-yield problem could ease were the Bundesbank to ask for a remedy, but there's little reason to think such a request is going to be made. This looks like a coordinated German approach to hastening the end of QE. 

So Le Spread is heading for tougher times. The Bundesbank seems uninterested in pushing yields up, and Gallic politics being what they are, French yields have little prospect of a decent leg down. An Economic and Monetary Union and politics don't mix.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Marcus Ashworth in London at mashworth4@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net