Europe's Record-Low 2-Year Yields Spark Doubt on Rally's Length

  • Skeptics remember April yield jolt after investor overoptimism
  • BNP Paribas, DZ say scope limited for further price gains

After investors read the Federal Reserve statement this week, and saw German inflation beat analyst expectations, they began questioning the sustainability of a sovereign-bond rally that sent short-term yields in euro-area nations to record lows.

The gains were supported by expectations of more monetary stimulus from the European Central Bank. Skeptics will remember that investors got ahead of themselves earlier this year, when jubilation over the ECB’s program was punctured, and the benchmark German 10-year yield jumped by more than 1 percentage point in less than two months.

Daniel Lenz, lead market strategist at DZ Bank AG said the eventual size of ECB stimulus in December may disappoint investors and spark a selloff.

“Markets have very high expectations and, given the latest numbers, it may be that further speeches from officials will point to the ECB not delivering as much,” he said. Lenz, who’s based in Frankfurt, expects the German 10-year yield to climb to 0.75 percent in six months. “There will be more measures, but it’s a question of whether expectations are too much. Bund yields below 50 basis points don’t look sustainable.”

The experience of the first half of the year is a reminder to traders of dangers that may lurk, should it turn out they either have overestimated the potential for additional stimulus or have get caught off-guard by an improving economy as a result of those actions.

With its 0.4 percent year-end target for the 10-year bund yield already in sight, BNP Paribas SA believes the rally has “little room to extend” even as conditions remain favorable for real yields, or those which take into account the effect of inflation, analyst Patrick Jacq said in a report published Oct. 29.

Benchmark Yield

Germany’s benchmark 10-year bund yield was little changed in the week at 0.52 percent as of the Friday 5 p.m. close in London. Only two days earlier it touched 0.42 percent, the least since May. The 1 percent security due in August 2025 was at 104.59 percent of face value.

The nation’s two-year yields fell to a record-low minus 0.355 percent on Oct. 28, while countries from Belgium and France to Austria and Finland also saw record-low yields for similar-maturity notes.

The inflation rate of Europe’s largest economy unexpectedly rebounded to an annual 0.2 percent this month. Economists surveyed by Bloomberg predicted a rate of zero. The euro area’s five-year, five-year forward inflation swap rate, a gauge of price-growth expectations starting five years from now, reached 1.74 percent on Oct. 26, the highest since Aug. 10 based on closing prices.

Fed officials sparked a broad selloff Thursday, one day after they mentioned the possibility of increasing interest rates at their next meeting, scheduled for December.

“With yields already having fallen close to our targets, the rally has little room to extend,” Jacq wrote.

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