There is really only one story to talk about this morning. The German Bund mini-crash is the driving force behind all other global macro price movements over the past couple of days. The selling in the bund started on Monday, and has been relentless all week long.
During the past couple of decades, there has only been one other 3 day decline that was larger – the 1998 Long Term Capital Management crisis.
There has been no real obvious catalyst for the move. Yes, there was some hotter than expected inflation numbers out of Europe earlier in the week, but the bund was already declining before they were released. Some pundits are blaming Draghi’s comments from yesterday’s ECB meeting as the reason for the sell off. Draghi said the markets should expect some more volatility. I don’t see how that can be construed as a reason to beat the bund like a red headed step child. If anything, his commitment to staying the course was more bund unfriendly:
“Exit strategies are really a high-class problem, and we’re really far from that,” Mr. Draghi said after the ECB decided to keep interest rates at record lows as expected. “We’ve still got a long way to go.”
Remember, QE programs are not bond positive. They create inflation, and ultimately cause the long end to sell off. If I were to pick a reason for the bund carnage, I would say Draghi’s renewed commitment to following through with his QE program was the single most bearish factor in yesterday’s portion of the sell off.
But the reality is bunds are in a bear market. We had a huge move off the 0.05% bat shit crazy top in the bund market. It then consolidated for a couple of weeks. And the selling has now resumed. It’s that simple.
It’s not like a 95 basis point 10 year is some stupid high level. It is still an incredibly low yield. In fact, the ECB welcomes a steeper yield curve. When German 10 year yields were 0.05% and shorter maturities were all negative, the market was not functioning correctly. A flat yield curve anchored by negatives rates is not the stuff of a healthy financial market. This return to normalcy is a necessary condition for the European economy to start recovering.
It’s the speed that’s a problem
The German 10 year bund yield level is not a problem. But the speed at which it is zinging around is a big deal. When volatility increases, market participants are forced to reduce position sizes. This causes more selling, which increases volatility, and causes market participants to sell even more. The financial system has never been more leveraged and hung together by a shoe string.
Yet chances are the bund selling is overdone. I wouldn’t advocate trying to catch this falling knife, but it is getting that panicky feel. If you are shorting down here, you are counting on a bigger move than the 1998 LTCM credit crisis. Sure it might happen, but it is probably not the right bet.
What really scares me
Rather than betting on the bund selling continuing, it might be a good idea to think about shorting other financial assets. During the past two years, the massive bull market in European interest rates was one of the driving forces in the relentless bid to many financial markets. German bunds went from 2% at the end of 2013 before hitting 0.05% in the first quarter of 2015. On the way, many market participants bought a wide variety of different financial assets simply because they were cheap relative to German Bunds. Mexico 100 year bonds at 4%? Sure, put me in for 20MM – they beat buying bunds at yields with single digits. US 30 year treasuries at 2.6%? Look at that pickup versus bunds. I’ll take 50MM. European banks stocks yielding over 2%? Sounds awesome. Get me on the bid for 30MM. The German bund rally caused a tremendous amount of other financial assets to be pushed way higher than would have otherwise been the case.
Now that the German bund has shit the bed, these other assets will be under pressure. The selling has so far been rather contained, but my suspicion is the increase in bund volatility will translate into other financial assets becoming more volatile.
Many stock markets were already trading poorly, and the sudden collapse in German bunds is the last thing they need. The financial markets are an interconnected delicate house of cards. When one of the players starts flailing around, it increases the chances the whole thing comes tumbling down.
Don’t underestimate the importance of the recent volatility in bunds. And if you are bearish on bunds, think about betting on some other asset’s decline instead of shorting bunds. Volatility works both ways, and I am scared we could easily get a bund face ripper higher in the coming days. But even if we get a short squeeze in bunds, this will still weigh heavily on other asset classes. Increased volatility either way will cause participants to wind down trades.
If they owned a funeral parlour
For those who are short and contemplating covering, I offer you the following value added commentary this morning:
Fair value for Bund yield is 1.45%, says Morgan Stanley, citing money market rates, expected path for those rates, growth and inflation.
The sell side analysts who all loved the bund at 0.05% because the ECB was “running out of supply” to purchase now think fair value is considerably lower in price.
The bund forecasts from these mopes have been about as wrong as you can be. As Gordon Gecko would say, if these guys owned a funeral parlour, no one would die. Their new bearishness is a clear signal the near term decline is almost over.
How many times have we seen this movie play out? Every time you think Mr. Bund will finally be killed, he miraculously finds a way to escape. This time won’t be any different…
Thanks for reading,