I won’t lie to you and claim I had this problem in high school (I wasn’t nearly cool enough and there weren’t a lot of girls into D&D), but it’s probably being since my university days that I have been so… early. Yesterday’s call that bunds had seen their highs and the 10 year maturity wouldn’t hit negative yields has proven to be quite, premature.

I knew the trading had reached the emotional stage, but the mad scramble into fixed income accelerated overnight with a ferocity I wasn’t expecting.

This morning the German 10 year bund ticked at 1 basis point, and the US 10 year yield has broken serious support.

As I sat staring at the screen licking my wounds, I considered where I went wrong. No doubt I stepped in front of a freight train, so to some extent, I shouldn’t be surprised when I am run over. But I still contend we are in the midst of the blow off final push. All you need to do is look at the CNBC screen splashes to realize we are getting towards the end of this rally.

But I am usually better at picking turning points, and this time my spidey sense malfunctioned. As I pondered this embarrassing incident, I thought about what is driving this squeeze. Then it hit me.

Although I am not fussed about the fall out from Britain potentially leaving the European Union, the market does not hold the same sanguine view.

I have been underestimating the worries about Brexit. In my mind, whatever the British chose, it is not a big deal.

But the “stay camp” has been dramatically overplaying the potential fall out from a leave result.

In my mind, the countries don’t share a currency, and a Brexit would mostly just cause a bunch of bureaucratic headaches. There would be minimal market impact. It would be little more than the collapse of a sophisticated free trade deal.

You can count me in the camp of John Browne from Europacific Capital who claims any Brexit fears are overblown:

Instead, the main activities of the Pro-EU group have been concentrated on the economic and monetary catastrophe that would face the UK if it were to cut itself off from trading with the EU. Some call this, ‘Project Fear’. The actual underlying facts paint a somewhat different picture, one that makes the Pro-EU case appear misleading, even deliberately so.

The basic argument is that with about 50 percent of its current trade with the EU, the UK would face a catastrophic economic and monetary collapse if it left the EU. As a threat, this sounds potentially devastating. Doubtless it has persuaded some. But in the light of reality, a different and far less worrying image emerges.

The UK has the fifth largest national economy in the world, according to 2015 figures compiled by the International Monetary Fund. In its present state of economic stagnation, the EU can ill-afford to lose the UK. According to the March 2016 Statistical Bulletin from the Office for National Statistics, the UK has had a negative trade balance in goods with the EU that has averaged about $8 billion a month this first quarter. If the UK were to leave without being able to negotiate an independent trade deal, the EU economy might shrink by some $96 billion a year. The UK was the second largest net contributor to the EU budget last year. It follows that the 8 English regions (with Scotland, Wales and N. Ireland considered as ‘relatively poor’) may in aggregate be the second largest suppliers of future intra-EU money transfers from the so-called ‘rich’ to the poorer southern and eastern regions of Europe. In that sense, the EU needs the UK more than the other way round.

The Pro-EU camp ignore the trade balance issue completely and threaten, as did President Obama, that the UK would be left out in the cold, like Switzerland, and unable to negotiate its way out of a disaster. Switzerland is not an EU member and has an economy of less than a quarter the size of the UK’s. And yet from 2009-2013 she exported, on average, 4.6 times the value per person to the EU than does the UK (The Truth About Trade Outside the EU, William Dartmouth MEP, June 2015). With a negative EU trade balance, why would the UK be unable to negotiate, from outside, a trade agreement at least as good as that achieved by Switzerland?

Yet the market is definitely more concerned than either I or John Browne. And this is why I was early in my bund short call. Until this worry clears, it will be difficult for bunds to sell off.

I still contend the next big move will be lower in price, not higher. I am not covering my short, and will hang tough, but in terms of timing, I am assuming the ultimate top won’t be put in until Brexit is out of the way. If the polls stay close, then watch for maybe a June 22nd (the day before the vote) top. Regardless of outcome, I suspect it will be a sell the news reaction for bunds.

Don’t count Japan out yet

Next week the Bank of Japan meets. This time, there are practically zero expectations for the BoJ to expand their monetary stimulus. After their disastrous call last month, Goldman Sachs is strangely silent on the possibility of a surprise out of Tokyo.

Earlier this week, Hiroshi Nakaso, the Deputy Governor of the Bank of Japan, gave a speech where he said the following:

To avoid any misunderstanding, I would like to clarify that there has been no change in the Bank’s commitment to achieving the price stability target of 2 percent at the earliest possible time. Transforming people’s deflationary mindset and raising inflation expectations through this commitment is itself the aim of overcoming deflation, and at the same time the starting point of the effects of QQE and “QQE with a Negative Interest Rate.” Firms’ and households’ inflation perceptions have changed markedly under this commitment. While the Bank at the April MPM judged that it would be appropriate to examine the extent of the penetration of effects of “QQE with a Negative Interest Rate,” this does not preclude additional monetary easing if necessary. As for the outlook for Japan’s economic activity and prices, risks – such as uncertainty over the global economy and volatility in financial markets – continue to be skewed to the downside. Therefore, the Bank will continue to carefully examine these risks at each MPM, and take additional easing measures in terms of the three dimensions – quantity, quality, and the interest rate – if it is judged necessary for achieving the price stability target.

With this in mind, overcoming deflation as soon as possible through decisive monetary easing is absolutely essential to returning Japan’s economy to a sustainable growth path, while the Bank will be watchful of the various effects of its low interest rate policy including negative interest rates.

Yet, even though the BoJ supposedly has not wavered in their commitment to achieving their price targets, Japanese break even levels have plunged:

I believe there is a big disconnect occurring between the market’s belief about Central Banks’ commitment to price targets and their willingness to expand further. The market is convinced Central Banks have been backed into a corner where they can no longer expand their stimulus. I will take the other side of that trade. I don’t underestimate their absolute lunacy to keep printing at whatever the cost.

Shorting yen, through buying puts, seems like a great way to express that view. If there is any bank that will lead the next round of madness, it is the BoJ.

Thanks for reading,
Kevin Muir
the MacroTourist