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The "Failure" of the German Ten-Year Bond Auction

Greg Ip:

German bunds: Fun with bunds: NEWS that a German auction of government bonds ("bunds") flopped rattled markets today. Since bloggers don't spend a lot of time immersed in the mechanics of European bond auctions, I asked Lorenzo Pagani, of Pimco's European government bond team, to explain how Germany's auction process works and what the Bundesbank's role is. He replied:

In Germany the debt auction process is similar to other countries'.  Dealers can bid with size and price. The difference is that in Germany, the Debt Agency (Finanzagentur) will retain part of the new issuance all the time, usually 15-20%, so they do not need full demand to issue. Also, the requirement to be a dealer in Germany means making sure of a minimum allocation across auctions that is relatively low (0.05%), while in other countries this requirement is higher (3% for example in Italy). Germany doesn’t grant greenshoe options to its dealers. Other countries do. A Greenshoe option gives the dealer the right to buy the bonds for a few day after the auction at the same price of the auction.

Overall this means that demand for German auctions will tend to be lower—all else equal—than for other countries’ auctions. Since 2008, Germany has seen uncovered auctions 1 out of 5 times.

Today's retention amount was large, 39% of the 6bln target.The Finanzagentur issued only 3.9bln cash. They gave 3.9bln bunds to the market and kept 2.1bln bonds on their books. In the future they can sell this retention amount into the secondary market, raising cash. You may have read that the Bundesbank bought the unfilled part of the auction; this is not correct. The Bundesbank is not financing Germany; it just operates as an agency for Finanzagentur.

It is worth repeating that Finanzagentur always retains part of the bonds, so this part of the process is normal. Today the retention was larger than usual. This is probably due to low liquidity across market, lower incentive to place certain minimum size bids by dealers, and richness of bunds in general.

"Low liquidity across market" means "right now people in Europe don't want to trade away their cash for anything--not even bunds". "Lower incentive to place certain minimum size bids" I do not understand. "Richness of bunds" means "they are expensive creatures that pay low interest rates".

The ten-year German government bond right now has a yield of 2.268%, which is extraordinarily low. If Germany's financial position were "in doubt" in any way, it would be yielding a lot more than 2.268%.

What has happened over the past week is that markets have started demanding a 30 basis point premium for holding bunds over US 10-Yr Treasuries--a thing that they weren't demanding before. Is this because the market fears that in the chaos of a eurozone breakup it might not be able to turn bunds into cash just when it needed to, and so is now demanding a 30 basis point premium yield to compensate for the possibility of that eventuality? Is this because the market now fears (or hopes) that changes in eurozone fiscal or monetary governance will in the future give the eurozone not a slightly lower but a slightly higher inflation rate than the US, and so is now demanding a 30 basis point premium yield to compensate for the possibility of that eventuality? I don't know--and I don't think anybody else knows either.

UPDATE: in my email:

People are selling Bunds because they need the cash. That's the definition of a liquidity crisis - it's not when people are selling poor-quality assets because they want to, it's when people sell everything, because they have to…. If you have to raise cash in a hurry, you sell high-quality assets, not low-quality ones. Soros has made a ton of money out of understanding this, and he even gives away the advice for free in one of his books.

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