Financial market stability rests on steady bond yields

Significance Furthermore, liquidity injections by central banks are supressing bond yields. However, even a hint from major central banks that inflation is picking up faster than anticipated could roil stock markets, whose lofty valuations depend on yields remaining ultra-low. Impacts A communication blunder by a major central bank could exacerbate any bond market volatility and cause a sharp sell-off in equity markets. More transmissible coronavirus strains are reaching more nations and reigniting fears about the speed and efficacy of vaccine rollout. A record USD18tn of public and corporate debt is yielding a negative return, fuelling demand for higher-yield EM bonds and currencies. The trade-weighted dollar has fallen by nearly 4% since end-September to the lowest since April 2018; it is set to stay under pressure.

German Bond Yields and Debt Supply

Are Bunds special? This paper estimates the “Bund premium” as the difference in convenience yields between other sovereign safe assets and German government bonds adjusted for sovereign credit risk, liquidity and swap market frictions. A higher premium suggests less substitutability of sovereign bonds. We document a rise in the “Bund premium” in the post-crisis period. We show that there is a negative relationship of the premium with the relative supply of German sovereign bonds, which is more pronounced for higher maturities and when risk aversion proxied by bond market volatility is high. Going forward, we expect German government debt supply to remain scarce, with important implications for the ECB’s monetary policy strategy.