German shorter-dated debt in heavy demand

German short-term interest rates dropped to a fresh record low on Monday as traders anticipated the effect of New Year policy changes announced by the European Central Bank this month, at a time when market activity begins to ebb in the final days of the year.

The yield on two-year Bunds fell to as low as minus 0.816 per cent on Monday, in a sign of demand for ultra-safe securities used to underpin short-term lending between banks and hedge funds.

The record low follows the announcement that the ECB will next year start to buy debt yielding less than 0.4 per cent, the official deposit rate, removing a constraint which had prevented many short-term bonds being purchased under its €80bn per month quantitative easing programme this year.

“The ECB meeting, and the decisions they made are central to the direction of short-term interest rates,” said Ioannis Sokos, interest rate strategist for BNP Paribas.

Two-year debt is one of the most actively traded parts of the short-term bond market. Bond yields drop as prices rise in response to demand, and traders anticipate the central bank will soon swell the ranks of buyers.

Mr Sokos added, “because the front end has not been eligible for QE for so long, it’s reasonable to assume the ECB has a low existing holding of bonds at the front end”.

An extension of the monthly bond purchases out to the end of next year, and an official forecast for eurozone inflation to remain below policymaker’s 2 per cent target in 2019, has also left few expecting sharply higher short-term interest rates.

German Bunds are regarded as some of the safest securities available, and so are used as collateral in re-purchase, or repo, transactions.

Prices in European repo markets have reflected concerns over a shortage of available collateral, largely because of the ECB’s purchases of over €1tn of assets. Earlier this month, the ECB announced it would lend out those assets against cash, raising hopes that the squeeze would be addressed.

The overnight repo rate on German collateral remains very low by historical standards, at minus 69 basis points, according to Icap, but the rate is less negative than its levels in late November when it traded below minus 70 basis points.

For bonds which are hard to find and are termed “special”, repo rates remain as low as minus 1.2 per cent.

Last week, analysts at Mizuho wrote that while fears of a squeeze had abated, the facility would “need to be increased beyond its current size by around June 2017 to prevent further collateral shortage in German bonds”.

One effect of the collateral shortage has been to make it more expensive for investors such as hedge funds to position for higher interest rates, which may remove a source of upward pressure on bond yields. Late December is also a time when trading desks tend to be more lightly staffed than normal, and able to take fewer risks as the end of year approaches.