German government bonds are in increasingly short supply
The causes lie in a steep increase in demand on the part of central banks and regulatory requirements imposed on financial institutions. Since the financial crisis, institutions have been obliged to hold a much higher proportion of their regulatory capital in the form of safe-haven bonds. In addition, the German economy regularly generates a budget surplus. This leads to a fall in the volume of new debt and thus a decline in the supply of Bunds.
The available data does not allow an exact calculation of the tradable volume of Bunds in circulation, but estimates can be made. These are based on IMF data on German government bonds held by foreign central banks as currency reserves, publications by the German Bundesbank regarding its own holdings of Bunds, and ECB publications on the volume of such bonds held by German financial institutions to meet regulatory capital requirements.
Bunds: Demand from institutional investors vs supply
If the German government continues to pursue a balanced budget, the supply shortage will worsen. According to our estimates, the tradable volume would fall below €100 billion in 2022.
Freely tradable Bunds are becoming scarce
The shortage that is already evident may be one of the causes of a structural trend of rising prices/falling yields. Taking this into account when interpreting current yield levels is of paramount importance and could explain why yields on short-dated German government bonds have been well below the Eurosystem’s deposit facility interest rate since 2015.
Yield on BuBills vs ECB deposit facility interest rate
The scarcity of Bunds also limits the scope of action for future monetary policy measures. Re-launching the ECB’s public sector purchase programme (PSPP) in its existing form, for example, would be difficult. Under the programme’s established approach, the allocation of the ECB’s purchases is based on the ‘capital key’, a schedule that determines the percentage share of the ECB’s capital stock to be accounted for by the central bank of each member state. At present, Germany accounts for the largest share (27 per cent). Continued and, in future, even higher demand for Bunds on the part of the ECB would further exacerbate the supply shortage.
The implications for the capital market would be substantial. Bunds are a key benchmark for pricing purposes in the eurozone bond market and serve as a reference point for the calculation and assessment of various spreads. But the scarcer the supply of Bunds, the lower their liquidity. This is detrimental to pricing and can make prices less meaningful.
A comprehensive ramp-up of public-sector investment, financed with new long-term debt, would provide an obvious solution to the problem. It would make productive use of extremely low refinancing costs for the purposes of profitable infrastructure investments and would also increase the supply of safe (backed by infrastructure investment) German government bonds. However, it remains unclear how this approach could be made compatible with the balanced budget provision (‘debt brake’) enshrined in the German constitution.
How is the scarcity of Bunds affecting capital market participants at present? They are forced to turn to alternative investments. Based on assessments of our fixed-income fund managers, these alternatives include paper from issuers with a comparable risk profile, e.g. Dutch and Belgian government bonds and bonds issued by quasi-governmental or supranational institutions such as Germany’s KfW development bank or the European Stability Mechanism (ESM).
-  Expectations of potential interest-rate cuts do not offer a satisfactory explanation for this difference because they are not reflected in the market for futures on the deposit facility interest rate.
 Based on the capital provided to the ECB by the member states of the European Monetary Union and excluding Greece, as Greek government bonds are excluded from the PSPP.
Unless otherwise noted, all Information and illustrations are as at 26 August 2019.