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The Great Distortion: Post-ECB European Bond Market Yields

In the aftermath of the quantitative easing program announced by the European Central Bank negative yields are becoming the norm

In recent years we have encountered a number of new terms describing the current economic situation globally – ‘the great recession’, ‘the new normal’, ‘the economic malaise’, etc. Today, the European Central Bank’s (ECB) President will have the first chance to explain how the institution views a new term – ‘the great distortion’.

For the past couple of months, the ECB has been conducting its own bond purchasing program known as quantitative easing. After the U.S. Federal Reserve and the Bank of Japan have been actively intervening in their local bond markets, the Eurozone’s monetary master was left with no choice but to devise its own plan for similar action.

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Yields are in negative territory in Germany with maturities extending to up to 7 years

After the announcement of a bond-buying program totaling more than €1 trillion, the European bond and stock markets have imploded. The result is probably the most distorted government paper market in the world, where yields are in negative territory for a number of countries with maturities extending up to 7 years.

After only two months of bond purchases, the German 10-year bond is presently trading at 0.14%, after having traded around 1.5% a year ago. Negative returns are present across the bond yield curve up until the 7-year government paper, while the 2-year is trading at -0.28%.

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With a demand for German government paper exceeding the supply, we have already heard about negative interest rates business loans in neighboring Denmark. The Nordic country which is outside of the Eurozone has been keeping its currency pegged to the euro for decades.

Looking at the periphery, the situation doesn’t look much different. The bond yields in Italy and Spain are close to all time lows, however the rally has stagnated. (Bond prices move inverse to bond yields.) Despite the economic hardships which the countries have been faced with for the past 7 years since ‘the great recession’ started, they are still benefitting from 10-year rates close to 1.3%.

Looking at the current situation realistically, there are only two logical reasons why investors are parking their money in negative yields.

In the first scenario, they expect deflation in the Eurozone, which would then make their returns positive if the rate of deflation is lower than the rates on the bonds they are holding. The second case for negative yields is that investors are indeed so worried about the safety of their funds that they are willing to take the negative returns hit and park their money in the German government’s paper safe deposit box.

But we all know why investors are piling into European government paper right now – short-term speculative gains. The ECB’s market intervention is driving speculators to buy bonds cheaply and sell them to the central bank at a premium in a couple of weeks.

Some expect Mario Draghi to focus on the topic in his upcoming press conference later today. There are substantial doubts about whether he can say something really new about the issue.

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