Avoiding whiplash

Markets can force rethink of ECB German bond bias

More and more German bond yields are sinking below zero. Concern that Britain could leave the European Union (EU) is driving investors to safe havens and amplifying the impact of European Central Bank (ECB) President Mario Draghi's bond-buying programme. Low yields cut governments' borrowing costs, but there's a risk of whiplash.

Investors who buy bonds with negative yields are vulnerable, since they count on prices going up to make any profit. This means even a small setback can quickly turn into a rout, as occurred in 2015. It's easy enough to imagine scenarios, which could spark a rebound in German yields. For example, British voters might decide to stay in the EU. Or euro zone growth could pick up more sharply than expected.

Yet Draghi has no choice but to store up trouble. Blame rules which pander to German fears that the central bank is funding governments. The ECB is obliged to buy bonds roughly in proportion to the size of each euro zone country. Moreover, it can only buy a certain amount of any particular bond and is forbidden from buying debt that yields less than the official deposit rate. This is particularly true for Germany, which has relatively less debt as a proportion of gross domestic product (GDP) and low yields.

These rules amplify market moves. As more and more bonds become ineligible, the central bank has to buy longer-dated securities, which offer higher yields. Investors pile into longer-dated debt in the expectation the central bank will be a forced buyer, and hurriedly sell when rising yields make more debt eligible. Volatile risk-free rates damage other assets, hurting risk appetite.

The more pressing issue is that the ECB may run out of bonds to buy, weakening its pledge to fight deflation. Half of German debt is already out of the ECB's range, asset manager Pictet estimates. This problem can be addressed by tweaking the rules of the ECB's asset purchase programme. The most powerful way to do this would be to buy more bonds issued by highly indebted nations. This would be controversial, even though German savers are also up in arms about ultra-low interest rates. Still, the further yields slide, the less choice Draghi may have.