I have got burned several times in bunds recently, so let’s hope I know what is going on this time. Bunds are back at their resistance level and, I think, likely to trade back down into their range.

Why have people been buying bunds? There are two possibilities: fears about a protracted slump in the Eurozone, or contagion from Greece (as people sell peripheral Eurozone bonds and buy bunds instead). The first explanation is implausible: manufacturing numbers out of the Eurozone have been surprisingly good, and the general emerging-market-driven recovery story on which the markets are focused applies as much to the Eurozone as to the US. So Greek contagion seems likely.

Can the crisis push bund yields any lower? It could. Continuing peripheral woes in the Eurozone would mean more switching to bunds. But so far in the sovereign debt furore, bunds yields have not fallen below their current levels except for one spike in February when the whole thing was fairly new. And it cannot be good for Germany’s fiscal position to be lending money to nations for which default (or perhaps “restucturing”) makes good sense. These points, together with the strength of the economy, argue against a downside breakout for German bund yields.

One more point: deflation. Deflation is an ongoing risk for the Eurozone and a prolonged deflation could mean much lower bund yields. But even in the depths of the crisis they hit pretty decent support at 3% — a breakout now, with improving economic data, doesn’t look a reasonable bet.

The real danger with this trade, I think, is that investors are starting to better appreciate the scale of the problem. If that is the case, then bund yields could push lower.

Here are some charts. First the bund yield, from Bloomberg:

Now bund futures — long-term chart from Timingcharts.com; short-term chart, from IG Index, shows approx entry point and stop position.