German bunds may be a worthy investment

Jan 20 2010 by Andrew Miller, The Journal

LAST week, the European Central Bank (ECB) kept its base rate on hold at 1%, much as markets had expected, with the accompanying statement indicating that the economic recovery would be "uneven".

Indeed, in its statement, the ECB’s President, Jean-Claude Trichet, mentioned “a bumpy road ahead of us” and “a great level of uncertainty”. German government bonds, or bunds, rallied on the back of this as the market expects the ECB to continue to keep interest rates where they are now for most of the year.

Earlier in the week, Germany had published its GDP data for 2009. The data showed a contraction in GDP of 5% for the year as a whole – making this Germany’s worst post-war recession, with exports hurting the economy the most.

What was interesting was that employment fell by just 0.1% and that the public deficit was just 3.2% of GDP in 2009 (almost two-thirds less than in the US, UK and some of the peripheral EU economies such as Ireland, Greece and Spain). The recession in Germany – though relatively deep – has simply not had the same impact on the labour market and public finances as elsewhere.

In general, as economies recover, we would expect upward pressure on government bond yields (and more obviously so for countries which seem to be coming out of the crisis better than the others). However, in the current environment, we still prefer long-dated German bonds over long-dated US and UK bonds.

This is partly because the combination of a weak economy with relatively strong public finances favours German bonds over those issued by the US or UK. Both the US and UK face very tough fiscal decisions to return their public finances to some sort of order, and worries about new government bond issuance look set to persist for some time yet.

It’s also worth remembering that correlations between various government bond yields reached historic highs during the financial crisis and German yields – which used to trade at a lower level than US and UK yields – converged with those of the US and UK.

However, this “yield gap” has re-opened again as markets begin to price in a “return to normality” scenario. Looking forward, our economists expect that the spread between German yields and US and UK yields should widen further over the next few years, with UK yields showing a particularly sharp rise when compared to German bunds of equivalent maturity.

We also note that ECB did not participate in the so-called “quantitative easing” measures while the US and UK central banks bought billions of dollars of government debt as part of their asset purchase programmes. This, we believe, could increase inflation expectations, especially affecting long-end US and UK government bonds. By contrast, inflation expectations for Germany should remain anchored. There is also the prospect of greater supply-demand imbalances in the UK and US when these programmes cease.

That said, the gap between German versus US yields has already widened a lot, as we had forecast, and there may not be that much further to go from current levels. UK gilt holders however may still consider switching into bunds, keeping in mind of course that returns can also be eroded by transaction costs and the cost of hedging non-sterling foreign exchange exposure.

Andrew Miller is regional office head of Barclays Wealth in Newcastle