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    German Bond failure - US Bond and Treasuries next?

    Bonds caught between supply surge and deflation

    By David Oakley and Michael Mackenzie
    Published: November 14 2008 02:00 | Last updated: November 14 2008 02:00

    For any government looking to raise money in the capital markets in the next few months, there was an ominous development in Germany this week.

    A German 10-year bond auction failed - something more or less unheard of until this year - as cash-strapped banks and investors snubbed the government offering.

    It is a clear sign of straitened times when a benchmark bond in one of the most liquid markets in the world cannot attract enough bids to reach its target amount.

    Crucially, it raises serious doubts about whether governments can raise the vast amounts of debt needed to fund fiscal stimulus packages and bank recapitalisations in the current tough market conditions.

    Any sign of waning demand may force up bond yields - putting further pressure on public finances when they are already under strain.

    Nowhere is the issue more pressing than in the US.

    Tony Crescenzi, strategist at Miller Tabak, says: "In a world with finite capital and where sovereign nations everywhere are in need of capital to finance their financial and economic stabilisation efforts, the substantial increase in Treasury supply could become manifested in higher long-term interest rates."

    Rick Klingman, managing director at BNP Paribas, adds: "There is no doubt that supply will matter at some point as the financing needs are staggering [in the US]. If equities and the housing market start to see some daylight at the end of the tunnel, then supply will become a factor and translate into higher yields."

    Yesterday, the sale of $10bn 30-year bonds was poorly received and amid a strong rebound in stocks, the bond yield rose 16 basis points to 4.35 per cent.

    US Treasury supply is expected to hit record levels, in a range from $1,400bn to $1,750bn in the 2009 financial year, starting in October. In Europe, bond supply is forecast to rise to more €1,000bn ($1,247bn) next year - also a record high, according to Barclays Capital.

    The extraordinary thing is that, in spite of this huge supply, most analysts expect bond yields will fall. This is because many analysts are now anticipating a deep and protracted global recession, and talk of deflation is even stalking bond markets.

    Yields have fallen particularly sharply at the shorter-end of the bond curve, which is most sensitive to interest rate movements, because of the accelerating slowdown in the world's economies.

    Analysts say the economic backdrop is the key determinant of where yields will trade. At the moment equities are so unappealing to investors that bond markets appear more attractive, offsetting supply concerns.

    Some government bond yields are also historically low, around levels last seen in 2005, and much lower than in June when inflation concerns dominated trade. For example, German 10-year Bund yields are trading at 3.63 per cent, compared with 4.68 per cent in June.

    Riccardo Barbieri, a strategist at Bank of America, says: "In the unlikely event that yields should rise, which I would not expect, they are coming from a fairly low level."

    Germany - in spite of its fourth 10-year Bund failure this year - and the US are likely to be more successful in attracting investors and depressing yields, should the difficult conditions persist, than other countries as they have the most liquid markets and are seen as safe havens.

    Analysts agree they will outperform smaller European countries, particularly the so-called peripheral nations of Italy and Greece, which have large levels of debt that could prove difficult to finance in a severe slowdown.

    This has been apparent since the beginning of the year with benchmark yield spreads across the curve between Germany and Italy and Greece widening sharply to record levels. Even in the event of - Italian and Greek bond yields falling, they may not drop fast enough to make up for the loss in tax receipts from their contracting economies.

    In a scenario of interest rate costs being greater than growth, the stock of debt rises, making economies with debt-to-gross domestic product ratios of 104 per cent (in the case of Italy) and 95 per cent (in the case of Greece) unsustainable.

    Meyrick Chapman, fixed income strategist at UBS, says: "This is a big issue and is a real problem for economies."

    The moderate success of Italian auctions yesterday highlighted the potential problems for Italy as it was forced to pay investors higher yields for three benchmark bonds. The Spanish government was also forced to pay investors more to cover its bond auction on Wednesday. Last week, Ireland struggled to raise money for a syndicated three-year bond, while Belgium has cancelled an auction in recent weeks.

    "People are investing for preservation in these markets, not for returns, which means they want safe bonds," says Mr Chapman.

    Another problem for the governments is the competition from banks and financial institutions, which have sovereign guarantees yet offer much higher yields.

    For example, this week the UK's Nationwide priced a three-year deal at close to 100 basis points over gilts.

    "The simplistic question is, why buy government paper when you can buy government-backed paper such as this for a much greater return?," says Sean Shepley, fixed income strategist at Credit Suisse.

    An expected €1,600bn of bank-guaranteed issuance in Europe alone next year could have a significant impact on investor appetite. Mr Chapman says: "In spite of the prospect of this huge issuance, yields are not being forced higher. This shows just how gloomy people are about the economic outlook."
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