Political risk drives German two-year bond to record low

A turbo-charged rally in short-dated German bonds has pushed the country’s yield gap with the US to its highest level in nearly 20 years today, underscoring diverging monetary policy paths for the world’s two largest central banks and escalating fears about European populism.

Germany’s two-year “schatz” bond has shed another 5 basis points this morning, driving its yield to a fresh negative low of minus 0.93 per cent.

Investor demand for short-dated German bonds has ramped up in the past two weeks as the European Central Bank has started to buy up the paper as part of its quantitative easing measures – pushing up bond prices.

Jitters about the political stability of the eurozone in a major electoral year has also driven investors to the “safety” of German bonds, pushing its two-year and 10-year yield spreads with France to the widest since the eurozone crisis.

The record negative yield on Germany’s two-year bond means investors are guaranteed to make a loss should they hold the bond to maturity.

Late last year, the ECB announced it was dropping its restriction on government debt purchases below its deposit rate of -0.4 per cent. Germany has proven to be the biggest beneficiary of the move, allowing the Bundesbank to snap up schatz to hit its monthly QE targets.

The US-Germany two year spread is now over 2.12 percentage points, according to data from Bloomberg – its widest since the start of the single currency in 1999.

Germany’s short-dated bonds are now one of the “most sought after assets in financial markets” said Peter Schaffrik at RBC Capital Markets.

“The recent uncertainty and spread widening in European markets adds another layer to the demand for German assets”, said Mr Schaffrik, who expects the bond’s price to keep climbing in the current political and monetary policy environment.

While the ECB remains intent on keeping on the QE taps until at least the end of the year, markets are pricing in two rate hikes from the Federal Reserve in 2017 in response to Donald Trump’s plans to raise spending and cut taxes in the world’s largest economy.

The policy-sensitive two year Treasury yield has leapt from a low around 0.5 per cent in July last year to over 1.22 per cent today.

Charts via Bloomberg