Yields could creep even lower on 'toxic cocktail'

The world watched this week as yields on the euro zone's benchmark bonds ticked closer to zero with some fixed income experts predicting there's still more room to fall for the safe havens.

Yields on government bonds have an inverse relationship to the price and Germany's debt has been a shelter for investors amid the euro zone's economic travails.

Many market-watchers feel that investors won't pull out of bunds any time soon even though the European Central Bank (ECB) has launched a further slew of stimulus. It is feared the latest round of bond-buying and ultra-cheap long-term loans will do little to generate inflation which can erode the purchasing power of a bond's future cash flows.

'Fairly toxic cocktail'

Cathal Kennedy and Peter Schaffrik, an economist and a strategist at RBC Capital Markets, believe there is a "fairly toxic cocktail for risky assets generally" in this current environment and sees downside for core yields in the European bloc.

"We see further risks ahead for all sorts of risky assets. Thus, we would advise reducing risk in spread products at present – despite the ECB's purchase program – temporarily," they said in a note Wednesday.

"We also think that (German) bund yields, even though back at the all-time lows in the 10-year seen last year, are not due any quick sell-off and might, in fact, head to fresh lows yet."

Spreads are the difference in the yields of core German bunds and those from peripheral nations like Portugal and Greece. RBC Capital says that yields on the latter may have been pushed higher due to low supply and the renewed uncertainty over Greece following the International Monetary Fund leaks over the weekend.

On Tuesday, the yield on Germany's benchmark 10-year bund dipped below 0.1 percent for the first time since April last year. It hit 0.081 percent intraday, coming close to an all-time low, and moved U.S. Treasurys which fell in sympathy. On Wednesday morning, the 10-year yield had edged back to 0.120 percent.

Recovery in 'serious doubt'

The move towards zero comes after Japanese bonds fell into negative territory earlier this year with investors effectively paying the government to hold its paper.

Peter Chatwell, head of European rates strategy at Mizuho International, highlighted that PMI (purchasing managers' index) data out Tuesday was also "weak," especially for France and Italy, and widened the spreads further in the euro zone.

European Central Bank president Mario Draghi
Darrin Zammit Lupi | Reuters
European Central Bank president Mario Draghi

Mario Draghi, the president of the ECB, and his lieutenants have been a major buyer in the sovereign debt markets but had added corporate bonds to their asset purchase programs as well as giving out cheap loans to banks. But growth still remains fragile and inflation is nowhere near their target of close to 2 percent.

"Without decent growth, the recovery is in serious doubt, and without a growth-expectations recovery, periphery debt is only sustainable in a Japan-like yield environment, which is not what the periphery enjoys currently," Chatwell said in a note on Wednesday morning.

He also believes that the technical picture for fixed income means there is further room for bund futures to rally, which would edge yields even lower.