Germany’s debt dynamics have proven to be the European success story, until last month. That climate is changing as the yield on 10-year German bonds, or Bunds, have made big moves. As of last week, this yield is near 3%, a dramatic rise from its early January rate of 2.6%. With inflationary pressures and changing economic forecasts, analysts are closely monitoring the implications for both investors and policymakers.
The German 10-year yield has, of course, been on the rise since it crossed the 2.6% level back in early January. In turn, in the first 3 weeks of this year the yield has averaged 2.6%. This is the reason that borrowing costs in Germany (and across most of Europe) were stable, though low. Right now that’s less than 3%. This leaves open the questions of what future economic conditions will look like and how the European Central Bank (ECB) will react to those conditions.
Current Economic Indicators
Inflation—specifically, German inflation—has become the most important driver of the bond market. Today, inflation is running at 2.3%. Experts agree that it will hover there, or slightly more than 2%, in the months to come. Even under the rosiest of scenarios, inflation is expected to soar above 3.3%. The spread between inflation rates and bond yields is the widest in history. The absence of any risk premium suggests the current yield of 3% is not reflective of economic uncertainty.
What’s more—in spite of the ECB’s inflation target—the German 10-year breakeven rate is still below 1.8%. This chart depicts the market’s inflation expectations over the next ten years. It’s showing a chasm between real inflation and what bond investors expect. With inflation still making waves, investors should be on the lookout for new potential risks and implement strategies to mitigate them.
The real yield of German 10-year bonds is about 0.75%. This ambitious figure represents the yield, adjusted for inflation. It brings into stark relief the long-term purchasing power risk of investing in German debt. As inflation expectations increase, the value of bonds returns could erode in real terms without a compensating rise in yields.
Comparative Rates and Market Expectations
The current three-month Secured Overnight Financing Rate (SOFR) is 4%. In the meantime, the ten-year SOFR rate is just under 3.7%. The two-year SOFR rate is near 3.4%. SOFR should eventually reach fair value at 3.75% and 4%, analysts expect. They project this transition to happen once the Federal Reserve puts a lid on its rates, settling at about 3%. This provides a useful backdrop for judging the attractiveness of German bonds in relative terms on a global scale.
The latest move has left the German 10-year Bund yield looking increasingly at odds. We hope to see it come into closer agreement with what the market is demanding. Certain analysts would argue that the fair value for this yield should be closer to 3.6%. They contend that levels are inadequate to account for the economic realities of the day. The bond market is going to be very sensitive to these dynamics. Its response will depend on how inflation trends continue to develop, in Germany and more broadly.
Outlook for Investors
As investors move through this new market paradigm, getting a grip on the relationship between yields and inflation will be crucial. Alternatively, investors could be forced to re-evaluate their strategies as German yields rise. This occurs at the same time as major volatility may be introduced by central bank policy pivots in response to new economic data.
Even bond investors may be taking a hard look at their risk tolerance right now. Such a shift would likely see the German 10-year Bund yield find a new range of 2.75% – 3%. Given high inflation concerns and a uniquely low breakeven rate, investors in the market may have to drift between the two worlds.