German bunds face a potentially poisonous cocktail of resurgent inflation and wage increases which could hit home later this year, Kames Capital’s David Roberts has warned.
Roberts, the head of fixed income at Kames and co-manager of funds including the £720m* Kames Strategic Bond fund, said while yields on German bunds could decline further towards zero in the very near term, on any reasonable timeframe the bonds faced very serious headwinds.
“If you look at bunds in anything other than the shortest possible timescale, the risk becomes very clear,” Roberts said.
“The bonds are potentially poisonous on a 6-month view, for example, once near-term deflationary pressures subside. We are seeing increasing evidence of wage pressures in core Europe starting to crop up, and if you were to remove the European Central Bank (ECB) core bonds would be materially higher.”
Bund yields are currently trading below 0.2%, having dived from over 1.5% a year ago, as the threat of deflation and a lack of growth combined to convince investors of the need to protect their portfolios by focusing on safe haven German debt.
Now, with the ECB launching its own form of quantitative easing, investors feel comfortable yields can continue to move lower.
However, Roberts said the trade now looked far too risky for investors. He noted some internal forecasts from ECB staff have CPI inflation in Europe back above target in 2017, while a weaker euro and a marginal recovery in commodity prices in the last few weeks could see inflation return faster than expected.
“What we seeing is a potentially dangerous cocktail for bunds brewing in Europe, and investors need to be aware of this,” Roberts said.
“If the signs of a structural improvement across parts of the Eurozone continue, then we expect yields on 10-year bunds will be back above 50bps in six months’ time, and possibly close to 1% by the end of 2015 if other central banks such as the US Federal Reserve start to raise rates.”
While Roberts said investors should not stand in the way of QE in Europe, he noted how yields on other safe havens moved back out once QE was instigated and growth returned.
With yields so low on bunds in particular, he therefore said any move down from current levels should be used as an opportunity to take profits and close out any exposure.
“Bunds look like a definite short at these levels, and any move lower in yields in the very near term should be used as an opportunity to take profits from a trade which is now far too long in the tooth,” he said.
“While the ECB is happy to purchase bonds for now, if these nascent signs of structural reform in Spain, Portugal and Italy gain traction and help the economy to recover, Draghi will stop buying, and yields will blow out to more realistic levels.”