HEARD ON THE STREET

April 10, 2012, 1:39 p.m. ET

Gentlemen Prefer Bunds
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By RICHARD BARLEY





Germany is turning financial logic on its head. Government-bond yields hit record lows Tuesday—with two-year yields even falling below those of Japan. Yet in many ways, Germany is booming.



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Unemployment, at 5.7%, is the lowest since reunification. Wage demands are picking up, with the powerful IG Metall union seeking a 6.5% increase. Real-estate prices in some cities are rising fast.


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And the economy, having recovered from a deep recession, is holding up. Traditionally, that would be a combination that signaled rising bond yields.






Instead, they are plumbing new lows. Disappointing U.S. jobs data provided the spur for the latest lurch down. But the renewed escalation of the euro-zone crisis is a bigger and more persistent factor, driving those seeking safety into bunds.






On the face of it, German bunds look hugely overvalued. Euro-zone inflation is expected to be 2.6% in March, well above the European Central Bank's target of just below 2%. A rule of thumb for 10-year yields is that they should be equal to expected nominal growth plus a modest risk premium; that would suggest German bunds should yield more than 3%. Yet Tuesday, they were at 1.64%. Two-year yields fell as low as 0.09%, versus 0.12% for Japan.



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Germany is gaining at the expense of others, however. Spanish borrowing costs are soaring, with 10-year yields close to 6%, up nearly 1.4 percentage points from their February lows. Italian yields are rising sharply, too. The ECB's bond-buying program looks like it is in hibernation, meaning there is little check on higher yields. While the euro-zone firewall has been enlarged by combining the European Financial Stability Facility with the new European Stability Mechanism, both Spain and Italy are on the hook for large capital contributions to the ESM. And yet both are in recession; Spain is grappling with an 8.5% budget deficit, while Italy has debt of 119% of GDP. That may raise doubts about the firewall's efficacy if it is truly tested.



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Germany has become effectively the only safe-haven government-bond market in Europe, as the only large market with intact triple-A ratings. Politics in the near term may increase bunds' allure. While French yields look far more realistic, with 10-year bonds at 3%, investors nervous about the outcome of France's presidential elections may prefer the safety of German debt. Greece's May elections could yet provide headlines that unnerve the markets, given the growing support for extremist parties.


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Early March's move higher in global bond yields led some to declare the start of a new bear market for bonds. On valuation grounds, investors may well have doubts about German bunds. But fear of a new euro-zone blowup may well trump those concerns—and drive German yields lower still.

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