LONDON: German Bund yields were on track on Tuesday to post their biggest annual fall in six years in 2014, with political turmoil in Greece and expectations for further monetary easing by the European Central Bank the latest drivers of the unexpected bond rally.
The top-rated euro zone benchmark held near a record low of 0.542 percent set on Monday as investors ran for cover after the Greek parliament rejected the prime minister's nominee for president.
The vote paved the way for early elections and another growth-crippling period of uncertainty in the country that has been the epicentre of the bloc's debt crisis and been bailed out to the tune of 240 billion euros.
A year ago a Reuters poll forecast that 10-year Bund yields would rise in 2014 and end the year above 2 percent. Instead, they have fallen 139 basis points, the most since 2008. An extra 2 basis point fall by the end of Tuesday, the last trading day of the year, would make it the biggest annual drop since 1998.
The forecasts may have factored in some risks in Greece, but were assuming higher growth and no risk of deflation and did not foresee increased demand for low-risk assets due to geopolitical tensions in Ukraine and a worsening situation in the Middle East.
With the euro zone economy barely ticking over and inflation seen at minus 0.1 percent in December, the European Central Bank is expected to launch early next year a programme of large-scale bond purchases, known as quantitative easing (QE).
"The reason things went differently is that nobody expected those deflation concerns," said Daniel Lenz, a strategist at DZ Bank. "It turned out to be a huge problem and the starting point of QE speculation. QE was the game-changer."
At the beginning of 2014, DZ Bank analysts expected, like most market participants, that Bund yields would rise this year but changed their minds over the summer.
NO YIELD
Data on Tuesday showed that Spanish consumer prices fell 1.1 percent year-on-year in December, their fastest drop since July 2009, largely as a result of cheaper oil.
Bolstering calls for more ECB stimulus, lending to euro zone households and companies contracted further in November.
Expectations of ECB easing are effectively wiping off the yields on German debt and pushing borrowing costs to record lows elsewhere in the euro zone.
In Germany, investors have to buy bonds maturing in at least five years to get even 2 basis points of interest.
Short-dated yields are likely to remain low as inflation is not seen picking up any time soon. But 10-year yields may rise slightly, according to a Reuters poll in which the median forecast is 1.15 percent for the end of 2015.
Two main arguments are behind the forecast. First, once the ECB launches QE, the market would have to price in a chance that it would work and adjust higher its long-term inflation and growth expectations. Second, the U.S. Federal Reserve is expected to raise interest rates next year, potentially pushing government borrowing costs higher across the board.
Italy held the last euro zone debt sale of the year. It sold 7.3 billion euros of bonds, with the yield on the 10-year falling to a new record low as QE bets supported demand.
Any ECB bond purchases are likely to keep yields on low-rated euro zone debt subdued next year. Ten-year Italian yields fell to 1.93 percent, while their Spanish equivalent traded at 1.63 percent, a new low.
"With further easing measures expected by the ECB, the market environment should remain positive," said Luca Cazzulani, a rate strategist at UniCredit.
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