Torschlusspanik und Weltuntergangsgeschichten

The German 10-year yield hit an the all-time low on April 20th at 7 bps. Since then, the German 10-year yield has risen by an impressive 1360%, cracking 100 bps this week. In context, this is a +90bps increase, but in any context it is a massive move. In cash price terms, this is nearly a 10% drop—which is carnage for a bond fund. The Germans have taken to calling it a “Torschlusspanik”.

It’s spreading. Sovereign bonds across the EU are seeing yields reverse.

You even see it in treasuries and JGBs.

It’s painful to be sure, but not an 'apocalyse' or some other sensationalist riff. It's just what happens when money gets complacent and parks their money in an asset because everybody else is doing it. It’s a necessary adjustment that transfers money from the complacent to those who are sniping them. I certainly don’t mind the hysteria within bounds (until the talk turns full-on stupid, full of apocalypses and hyperinflation scares): when the bond market starts hitting the headlines the adjustment has pretty much run its course.

There are a lot of technical reasons why this sell-off took place, though there isn’t a very good answer as to why the sell-off took place precisely when it did.

Bond futures and their underlying cash markets are lower liquidity markets compared to equities. Lower liquidity markets correspond to better trends, perhaps because you can't count on the market chopping back and have to get on or watch it go. Bunds contracts in particular trend pretty good. It has its own idiosyncrasies, driven by the different participants in the market. Given the proportion of prop / local traders that are trading it, you need to keep that in mind when approaching your trades - for example, what might be a perfectly well placed stop in one market is screaming for someone to hi/low tick you in the bunds. When you are on the wrong side, it can be a very tough market. The market is thin sometimes and you can see massive moves—just look at the last couple of months for confirmation. Futures contracts for all bonds have generally nice features like decent volume, and a trading pace that makes it easier to get in and out of markets and be scalped doing it, and your stop levels hold up. Trading is definitely not boring nor does it automatically imply getting scalped.

Aside from these technical matters, sovereign bonds yields are still extremely low historically speaking. Massive central bank easing has driven yields to these levels. And there is a longer term trend unwinding in Europe, a de-unification process, at least in bonds yields. You can see the dynamics clear enough below.

Added to this is the expectation of modestly rising policy rates by the Fed creating a shift in the market from complacency (the undervaluation of incoming information) to panic (an over-amplification of incoming information). The market has merely moved from over-amplification of one type of signal to over-amplification of another type of signal.

The de-unification of EU sovereign yields and the likelihood of rising rates are meaningful and impactful, but at the same time they are rather open-ended in their implication. Just because EU bond yields decouple doesn’t mean that the political union in Europe is going to decouple. At the same time, rising rates hit risk markets, but there is no surety that rates will actually rise, let alone knowing how much. So there is a wide range of possibilities as to what they mean for bonds.

Markets are just adapting to changing news, and in some cases buyers and sellers are getting ahead of themselves. Markets are forever in vain trying to shove the wildly fluxive, kaleidoscopic nature of a human system into the equivalent of a happy-meal box.

This is where over-amplification steps in. People construct a larger narrative that dwarfs what is implied by the data itself. Germans call “Weltuntergangsgeschichten”, where a gaggle of more dumb people believing dumb things, once again, as the rest of us merely sigh and shake our heads.

There is a broad range of these doomsday stories that attempt to explain what got the world to negative yields in the first place. Robert Gordon imagines that over the next 25-40 years, the US economy is likely to generate only 0.9% per capita GDP growth annually, against the historical 1891-2007 average of 2.0%. That will happen because of four ‘headwinds’ and the decline in innovations since 1972. The four headwinds are: demographic headwinds (as the increase in the participation rate turns to a structural decline). About half of the decline in the last seven years could be due to ageing; the end of the education windfall, with 40% of college graduates unemployed. Student debt stands at US$1 trillion; inequality giving more to those who save rather than spend; and the rising debt/GDP ratio of the US federal government that could reach 150% by 2040.

Another flavor of quasi-doom posited by Kenneth Rogoff indicates that the global economy is in line with that seen in the aftermath of past financial crises – both theoretically and empirically. The euro area crisis and the rise and fall of EM are elements unique to this period but the ‘debt supercycle’ explanation still explains the situation the best. A secular drag on growth does exist, but it comes from forces such as demographics and the normalization of growth in China/Asia. Global growth will likely slow down from the pre-crisis decade highs to the 50-year average of 3.9%. The happy ending in this story is that once deleveraging and borrowing headwinds abate (happening in the US, less so in the euro area and even less in China), growth will resume and could surprise today’s extrapolated, depressed levels to the upside.

It is true that essentially deflationary forces driving bonds yields lower remain intact. But this doesn’t mean that bonds should have a negative yield to maturity. A deflationary back-drop does not imply that nominal bonds should naturally reduce to an asset that provides all risk and no return. So a sell-off is a necessary correction. Nor is there any meaningful evidence that inflation is out-of-control. If this was really about roaring inflation or expectations of it, you would not see linkers selling off in lock-step with nominal bonds. So we likely won’t be seeing the 10Y at 6% anytime soon either.

If you stick with the facts obtained from market data, you will always be in a better spot than trading some Weltuntergangsgeschichten. As long as you have the CB on the other side of the table, you only can lose, baby.

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