German Two-Year Bonds Have Negative Yield, Demand High; Euro Bond Bubble Guaranteed to Burst

Central bank money madness continues with market participants expecting QE to begin in Europe. Will it spur lending? Of course not. Banks do not lend from excess reserves. Banks lend (provided they are not capital impaired), when credit-worthy borrowers want credit and banks perceive risks worth lending.

The ECB tried to spur lending by charging, rather than paying interest on excess reserves. The results are in: Yield on Two-Year German Bonds is Negative

German two-year debt yields held close to 15-month lows just below zero on Wednesday, with record low money market rates and expectations of easier ECB monetary policy underpinning demand at an auction of similarly dated bonds.

Germany sold over 4 billion euros of a new two-year bond, with demand from investors double that amount despite the average yield and the coupon both being zero.

A Reuters poll this week showed money market traders saw a 50-percent probability of QE in the next 12 months, up from a one-in-three chance in last week's survey.

"We've seen really bad growth numbers and these translate into deflation fears, which in turn fuel QE expectations," DZ Bank market strategist Felix Herrmann said, noting that risks around wars in Iraq, Ukraine and Gaza also supported demand at the German auction.

"All that argues for lower German yields for shorter and medium term maturities. There are few, if any, reasons for Bund yields to rise."

Two-year bonds yield minus 0.004 percent in the secondary market, meaning buyers will get slightly less money than they invested when the bond comes due. They first traded negative at the height of the euro zone debt crisis in 2012.

Some banks may prefer to buy such assets rather than being charged 10 basis points for keeping the money in the ECB's deposit facility - a result of the central bank's unprecedented deposit rate cut into negative territory in June.

That rate cut and the ample excess liquidity in the euro zone banking system has pushed the overnight bank-to-bank Eonia lending rate fell to a new record low of 0.005 percent.

Elsewhere in the euro zone, ECB easing expectations pushed other euro zone yields lower on Wednesday. Spanish and Italian 10-year yields hit new record lows earlier in the session, falling 6 and 3 bps respectively to 2.38 and 2.56 percent, before reversing some of those gains in the afternoon.

Portuguese and Greek equivalents dropped 12 and 10 bps respectively to two-month lows of 3.31 and 5.80 percent.