Beware the widow-maker
Over my 25 years in bond markets, there’s always been one trade that becomes known as “The Widow-Maker”. Being underweight long-dated gilts was one, at a time when new pension regulations sent yields plummeting, and shorting the Japanese bond market also became deadly as the Bank of Japan slashed rates to zero. Today, widows and widowers are being made in the German bund market. Yields on the 10 year bund are now trading at record lows: bond investors pay 31 bps per year for the privilege of lending to the German government.
As yields collapse, forecasts and expectations are quickly revised lower. In the wake of Mario Draghi’s ECB speech last week we even saw one investment bank speculate that the 10 year bund yield could fall from that -0.31%, to -2%! Madness? Well Draghi was incredibly dovish, and it’s easy to read his speech as being as important as his famous “whatever it takes” line in the midst of the 2012 eurozone crisis. We’ve already had more than €2 trillion of quantitative easing (QE), negative rates, forward guidance promising to keep rates low, and cheap loans to banks – what more could we possibly get?
Well, more of all of the above. Draghi is petrified by the collapse in eurozone inflation expectations, and by core CPI at just 0.8%, on top of horrible manufacturing figures and looming trade wars. As the Fed readies for multiple rate cuts in the US the € is strengthening against the $ too, another headwind for the eurozone economies. So he talked of the ECB not resigning itself to “too low inflation”, and of downside risks to the economy. Clear improvement is needed or easing stimulus “will be required”. This is likely to involve a cut in the ECB’s deposit rate more deeply into negative territory (the ECB has made peace with its negative interest rate policy at last), and the resumption of QE.
That resumption of QE does create more problems for policymakers though. Whilst the European Court of Justice (ECJ) has said that QE is legal (unless it serves to mask market expectations of default), there are limits on how many bonds the ECB is allowed to buy. Presently this is set at 33% of any outstanding issue, and that’s a problem when the Germans ain’t making bunds anymore. In pursuit of what they call “Black Zero”, Germany is running a budget surplus every year, which has seen its debt to GDP ratio fall dramatically in recent years. This means that bund issuance is exceptionally low, and that the ECB will quickly reach the limit on how many it can buy as part of any new QE programme. The market expects the 33% limit to be lifted to 50% in the event of any new QE, but to quote that investment bank “-2% forecast” note, bunds are “scarce potatoes”. Quantitative Easing will reduce bond yields further, but for bunds this result will be magnified greatly.
So how do you get from -31 bps yield to -200 bps yield? Well you need aggressive deposit rate cuts, from the current -40 bps to -120 bps. What does this do to Europe’s fragile banks? Do they become less profitable? Do households and companies hoard banknotes in safes to avoid negative rates? You also need the German yield curve to flatten (long dated yields falling by more than shorter dated yields) to something that looks like Japan’s, and for those bund “scarce potatoes” to become more expensive relative to other European fixed income assets. We still come back to the question – is it logical to pay someone to be able to lend them money? But we must also come back to John Maynard Keynes’s overquoted words – “the markets can remain illogical for longer than you can remain solvent”. Beware the Widow-Maker.
This article originally appeared in Investment Week – Read here
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