Yields on European government bonds hit record-low levels on last Thursday despite the forecast final rise in eurozone yields. There are, however, reasons for such a drop.

First, the economic news from the eurozone have been depressing of late. Business confidence dropped in April in Germany, France and Italy, yielding a sense of a rapid slowdown approaching. German economic growth forecasts have been cut for 2005. The European Central Bank now has little incentive to raise interest rates that have been at 2% since June 2003.

“In an environment where sentiment has turned in the credit market so that there is a lot less confidence in risk assets, there was likely to be flight to quality anyway,” says Gary Jenkins, analyst at Deutsche Bank. “Combined with a eurozone economy showing very little signs of growth, [these are] wonderful signs for government yields.”

The second factor is the indication of a slowdown in the US looming. The US GDP numbers that missed expectations, dropping to 3.1% in annualized rate in the first quarter, indicate that the economy may be slowing down.

European tumult accompanying the proposed adoption of the EU Constitution that is expected to fail in the referendums in France and Holland also increases the attractiveness of the German bunds that are taken to be safer.

The French referendum on the European Union constitution adds increased nervousness to the bond markets, as investors are more and more attracted to German paper. 10-year yield on German government bonds dropped to only 3.389 per cent last Thursday, its lowest level in forty years.

“This [spread widening] is significant,” said Steven Major, global head of fixed income strategy at HSBC. “Investors are worried about the implications of the referendum . . . risk aversion tends to benefit the German market.”

Greece and Italy have raised the cost of protection against a default in response to this development. The price of insuring Greek debt that amounted to €14,000 on €10m last month has now jumped to €23,000.
The fourth reason is the technical buying of bonds that supports prices after they break low levels, and yields are kept down.