German Bunds: The Short of the Century
Region’s woes make it difficult to be sure of what currency holders willl get when the securities mature.
It’s springtime for bunds and Germany, to allude yet again to the big production number featured in Mel Brooks’ classic movie and, later, Broadway show, The Producers.
But spring isn’t always the idyllic season portrayed by Romantic poets like Wordsworth, but sometimes the one Eliot described when he called April the cruelest month. And so it has been with traders of Bunds, who have been whipsawed as if caught in one of the twisters that often sweep through the midsection of the U.S. this time of year.
In a matter of a couple of days last week, the yield on benchmark 10-year German government bonds, known as Bunds, more than doubled. And from its low in the middle of last month, the yield has jumped 11-fold, making for an especially cruel April for leveraged long players.
To be sure, on an absolute level, those changes don’t look like much, but they demonstrate the bizarre effects of near-zero and subzero interest rates. For the record, the 10-year Bund jumped 20 basis points (0.2 percentage points) in just two days, to 0.37% Thursday, before much of continental Europe took Friday off for May Day. Back on April 17, the 10-year yielded a mere 0.033%, while shorter maturities’ yields were negative.
The bizarro state of affairs has been much discussed here and elsewhere. In recent days, this weirdness has spurred the once and current Bond Kings to suggest that negative interest rates not only are unsustainable, but also tradeable as short sales. Bill Gross, the former head of Pimco before exiting for Janus Capital, called betting against Bunds the short “of a lifetime,” while his rival, Jeffrey Gundlach, who heads DoubleLine Capital, similarly termed it the short “of the century” that’s just 15 years old.
As Gundlach expounded in a Bloomberg television interview, shorting two-year Bunds that yield minus 0.2%, and leveraging that position 100 times—not unheard of with relatively short-term, high-grade debt instruments—should return 20%. It’s a mathematical certainty that the bond will lose value by the time it matures at par in two years, resulting in that leveraged return.
That is, in a normal world, which is not necessarily the one we live in today. As the folks at BCA Research say, investors in Treasuries, United Kingdom gilts, or Japanese government bonds know that when their securities mature, they will be paid in dollars, pounds, or yen, respectively. “But if you buy a euro-area long-dated sovereign bond, you cannot be absolutely [their italics] certain that you will get paid in euros when the bond ultimately redeems.”
Or to quote another movie, buying a euro bond is a bit like a box of chocolates: You never know what you’ll get, as the title character in Forrest Gump observed.
BCA envisions a “small but not negligible 20% risk of a euro breakup” through 2020, or roughly 4% a year. They further posit that a reintroduced Deutschemark would be revalued 10% higher, owing to Germany’s fundamental advantage of higher productivity versus the rest of the euro zone. Conversely, a reinstated lira would likely fall 10% to reflect Italy’s lower productivity.
Thus, a German Bund should trade 40 basis points (0.4%) lower in yield to reflect this currency redenomination risk (4% probability times 10% windfall gains from a revived D-mark), while Italian bonds should yield 40 basis points more to compensate for the similar risk of loss from bringing back the lira. And with the European Central Bank keeping its rates basically at zero as far as the eye can see, bond yields will be anchored there.
Were that to happen, selling euro-denominated bonds with negative interest rates wouldn’t be the short of the century. While Mario Draghi has so far delivered on his famous promise to do “whatever it takes” to preserve the euro, even Super Mario could fall short.
Five years after the initial bailout of Greece, the Athens government again is teetering on bankruptcy. The gap remains wide between the EU—led by Germany and demanding further reforms in exchange for the credit Greece needs to stay afloat—and the Greek government that is overseeing an economy suffering from a deep depression. Devaluation traditionally has been the palliative for such economic pain. Remaining in the common currency removes that possibility.
For whatever reason, Bunds got whipsawed last week, surging in yield, which translates to a drop in price, which was the occasion for much head-scratching. As David Ader, head of government bond strategy at CRT Capital, noted, those moves followed the opining by Gross and Gundlach about how Bunds were a great short. “Their timing couldn’t have been better, or alternatively, they had the position and then supported it with the public pronouncement,” he speculated slyly. An equally plausible analysis comes from RBC Capital Markets’ assessment of Thursday’s bund selloff: “Simply speaking, all that had gone up went down.”
Why all this emphasis on what’s happening over there? Because it has been a major driver of what’s happening over here.
THAT’S READILY OBSERVABLE, with the benchmark 10-year Treasury yield maintaining a relatively constant spread of about 170 to 180 basis points over the comparable Bund. And the yield rise translated into steep price losses in long Treasuries; the iShares 20+ Year Treasury Bond exchange-traded fund (ticker: TLT) shed 3.9% last week, roughly equivalent to a 700-point drop in the Dow.
Bank of America Merrill Lynch economist Gustavo Reis writes that “global factors have been significant drivers of U.S. bond and equity markets.” Quantitative easing by major central banks has pushed stock prices higher and bond yields lower, not only in the U.S. but also in Japan and Europe. Moreover, even as the Fed last year wound down QE, the bond purchases by the ECB and Bank of Japan made up for it.
But there has been selling elsewhere, notably by the governments most dependent on oil revenue. Saudi Arabia’s currency reserves plunged by $36 billion in the most recent two months and are down $47 billion since last October. Russia reportedly also is burning through its reserves, although its central bank was able to cut interest rates last week (aided by the rebound in the ruble and its equity market, with the Market Vectors Russia ETF (RSX) up by about a third this year).
That’s also surprising, given the sharp rebound in crude prices from their lows in March, which almost exactly coincides with the recent reversal in the dollar’s advance. And as oil has reversed its slide, the inflation premium in the bond market—the so-called TIPS spread, representing the difference between yields on 10-year Treasury notes and comparable Treasury inflation-protected securities—has widened from a low earlier in the year of 154 basis points to 195 basis points Friday (based on a 2.11% 10-year and a 0.16% TIPS).
Other commodities, notably metals, also have levitated as the greenback has slipped from its highs. Another BofA report attributes copper’s recovery to short-covering. Iron-ore prices are up sharply, too, from their recently depressed state, amid expectations of further stimulus in China, including QE on top of the central bank’s recent reserve-requirement and rate cuts. (See this week’s cover story for more on China.)
All of which has left U.S. stocks betwixt and between. On Friday, Louise Yamada, who heads the eponymous Louise Yamada Technical Research Advisors, laughed charmingly when we asked for her thoughts on this crazy market. She admitted to have gotten defensive prematurely a couple of months ago as the big market gauges went “up, up, up” in the face of divergences in the indexes. In particular, Louise pointed to the percentage of stocks in the S&P 500 exceeding their 50-day moving average slipping below 50%, a sign of waning momentum. Meanwhile, leadership has shifted to sectors lacking the heft to lead the market higher.
To be sure, she emphasizes, these are signs of a correction developing within a long-term secular bull market. Thursday’s decline of about 1% in the major averages might have been the start of that, she adds, although they recouped those losses Friday.
Other disquieting signs include the steep, 20%-plus drops last week in social-media stocks, such as Twitter (TWTR), LinkedIn (LNKD), and Yelp (YELP.) But Apple (AAPL), which was off about 7% from its peak after reporting blowout earnings, halved those losses by week’s end.
Such action is consistent with stocks entering their usual seasonally turbulent period. While earnings reporting season is winding down, geopolitical and other economic events loom large. As noted, an agreement on Greece’s debt hasn’t been reached. The U.S.’s own Greece, Puerto Rico, last week voted down tax reform to bolster its budget, sending its bond prices to new lows. Britain has a general election this week, although David Cameron’s Tories pulled ahead in the latest polls.
Closer to home, April’s nonfarm payrolls report, due Friday. will be the focus of the week. Stan Shipley of Evercore ISI forecasts a return to the robust gains prior to March’s punk rise of just 126,000. He sees a 245,000 gain, the high side of consensus guesses. That should keep the Fed on track for a second-half rate hike, but not push for a June move, which was taken off the table by the weak first-quarter GDP growth of just 0.2%.
That was supposedly a result of another lousy winter, which was followed by a nice spring. But, as with boxes of chocolates, you never know what to expect.