THE ECB EXPERIMENTS

2016-06-08 3pm EDT  |  #ECB #bunds #Germany #QE

Yesterday the German 10 year bund closed at a record low yield. Now yielding a whopping 5 basis points, the 17 handle rally in the bund futures over the past year has brought out all the “inevitable negative 10 year bund yield” forecasts.

At the risk of losing fingers, I am going to try to catch this knife. I am already short bunds, but I am cranking up the position this morning.

The bund has been rising because of three main factors. The first and most obvious is the global economic slowdown. All bond markets have rallied as world growth has slumped. I still believe an overly hawkish Federal Reserve is the root cause for this economic stutter, but that’s not really the point. Bunds have risen along with all the other developed market sovereign bonds.

The second factor driving this epic chase into bunds is the ECB’s quantitative easing programs. Mario and his gang have been expanding their balance sheet at a BoJ like pace.

There has been all sorts of talk about the possibility of the ECB running out of bonds to buy. Investors are crowding into the remaining few positive yielding German bond maturities. Yet this is counter intuitive behaviour. If the ECB is successful in their Quantitative Easing programs, what will be the outcome? Increasing inflation. What is a sovereign fixed income investor’s biggest nightmare (assuming default is out of the question)? Inflation. Investors stampeding into German fixed income are assuming the ECB will not be successful in their reflating efforts. I will take the other side of that trade. As long as the ECB doesn’t waver, quantitative easing will create inflation and eventually be negative for long dated European fixed income. There is this huge misconception that QE programs are bond friendly, when all you need to do is look at the US 10 year yield with the American QE programs highlighted to realize they are in fact bond negative.

During all three QE programs we experienced increasing yields. And at the conclusion of each program, yields fell. Completely opposite of traditionally held views.

The ECB QE program is all the more potent because for the first time in history, the ECB is expanding its balance sheet by buying corporate fixed income. This is a bold experiment. It is sad the monetary transmission mechanism is so broken that this is necessary, but this happens when markets do not believe in the resoluteness of a Central Bank’s will. Regardless of the cause, this is again highly expansionary, and should ultimately prove bund negative.

To top it all off, this morning Draghi laid to rest any worries that he was going to stick to “safe” corporates. From Bloomberg:

The European Central Bank didn’t shy away from the region’s riskier securities when it began buying corporate bonds on Wednesday. Purchases included notes from Telecom Italia SpA, according to people familiar with the matter, even though Italy’s biggest phone company is rated as sub-investment grade by two ratings firms. The company’s bonds are in Bank of America Merrill Lynch’s Euro High Yield Index and credit-default swaps insuring the notes against losses are part of the Markit iTraxx Crossover Index linked to companies with mostly junk ratings.

Mario Draghi is showing he’s planning to make the biggest impact possible on the first day of corporate bond purchases by casting his net as wide as the program allows. While the ECB has said it would buy corporate bonds with a single investment-grade rating, some investors expected the central bank to start with the region’s highest-rated securities.

“This dispels any doubts investors may have had about the commitment of the ECB and the central banks to tackle lower-rated names,” said Alex Eventon, a Paris-based fund manager at Oddo Meriten Asset Management which oversees 46 billion euros ($52 billion) of assets. “Telecom Italia is firmly at the weak end of the spectrum the ECB can buy. It’s good for high-yield investors who might have bought these bonds to ride the rally the ECB created.”

The ECB is taking bold steps and should not be underestimated. And let’s not forget, the TLTRO balance sheet expansion still ahead of us. Later this month the ECB will expand their balance sheet even more aggressively with another “experiment.”

And the third and final factor driving bund yields lower is worries about Brexit. If the English vote to leave, and that proves to be the tipping point towards more countries exiting the union, then German bunds would be a logical safe place to hide. This has caused bunds to be even better bid than otherwise would have been the case over the past month.

All of these factors have combined to create an atmosphere where investors are piling into bunds like they are the last lifeboats on the Titanic. Even Bart has given up trying to fade the stampede.

When the shrill sounds about “inevitable” moves hit the tape, it is time to fade the hysteria. Amongst a large portion of the trading community, it is now taken as a “given” that 10 year bunds will trade at negative yields in the coming weeks.

On the other hand, I think:

  1. there is too much pessimism about the global economy. Sure it stinks, but everyone knows that, and it is built into the price.
  2. the ECB is “all in” and will reflate or die. Contrary to popular belief, this is negative for bunds.
  3. although I don’t know whether Britain will leave the EU, I think any potential fall out will be much more muted than market concerns.

I am here to say, “not so fast. Sold to you.”

The short side of the bund market seems like a great trade. Buying puts (being long gamma) is a terrific way to express this view.

This morning the European markets are hopping around like a rat on acid, but make no mistake, we are close to a tipping point. These sorts of emotional moves often mark the turn. I suspect we will look back and wonder what we were thinking trading 10 year German bunds at 0.05% with a Central Bank actively expanding their balance sheet into risky assets.

Thanks for reading,
Kevin Muir
the MacroTourist