German bond prices could fall as much as 35 percent when the crisis in the euro zone comes to a head and their safe haven status becomes less attractive, Carl Weinberg, Chief Economist at High Frequency Economics said on Friday.
Yields on German government bonds have fallen to record lows as investors, averse to the high degree of risk in currently very volatile markets, look for safe assets.
10-year Bund yields have fallen below 1.2 percent and yields on 2-year German Bunds are at 0.0025 percent.
That compares with yields of around 7 percent for Spain, a level which many analysts say is unsustainable but which remains stubbornly high due to the country’s high levels of debt as well as an unfolding banking crisis.
Germany’s safe haven status has become so ingrained that it even paid no interest to borrow over two years last month, the first time this has happened for a bond with a maturity date 2 years away.
“Bund yields have reached unsustainable lows,” Weinberg said. “When we see numbers like this, we start to get the same queasy feeling in our gut we had when the NASDAQ breached 4,000 back in 2000, or when house prices exploded in 2005,” he warned.
He expects Bund prices to crash “with vigor” either when the market realizes they are not so safe after all and that Germany’s public sector finances are vulnerable to trouble in the banking system, or “when the banking crisis comes to a quick head and safety no longer commands such a premium.” Weinberg pointed out 10-year Bunds had seen an appreciation of some 22 percent since the start of the problems in Greece.
Yields have dropped from 3.8 percent.
He argues that if “real” 10-year yields of 2.5-3.5 percent are normal and reflect trading before the Greek crisis, then – taking inflation into account - normal 10-year yields ought to be in the 4.5-5 percent range.
An increase in the inflation rate generally leads to higher interest rates, and when new bonds are issued in a higher interest rate environment they will have a higher yield.
“So figure the ‘risk premium’ included in the Bund yields today is 300 to 350 basis points. When the snap comes, and yields return to normal levels, prices will drop by about 35 percent,” Weinberg said.
He added that a capital loss of 228 billion euros ($281 billion), 35 percent of the 652 billion euros in Bunds outstanding at an average duration of about seven years, was “probably a high estimate” but he believes it is indicative of what could happen when Bunds are no longer considered a safe asset.
“After the crash in the Euroland economy and the banking system we fear that a monster crash in the prices of bonds bought as ‘safe haven’ securities will rock the system with a second hit. The bubble in 'safe' Euroland bonds is, in our view, already well inflated,” he said.