Betting on a return of the DeutscheMark!
Whilst the news yesterday centered on the fall in US 10yr Treasury yields to levels not seen since 1946, the bigger news maybe that the new German 2yr Bond at one stage yesterday traded above 100. Given that the coupon on the Bond is zero percent than that means that the yield fell into negative territory at -0.002% . Now it has happened before that short-term Government yields have moved negative, the summer last year saw US Tbill yields in negative territory- but at the time the Fed Funds rate was also at near enough zero and 2yr US Treasury yields did not fall below Zero, hitting 0.14%. In Europe the ECB deposit rate is still at 0.25% so banks and corporations can place money on deposit at their own Central bank at that “safe” rate. So why buy 2yr German Bunds at zero yield?- 1yr Bill rates are at zero as well wouldn’t they be a better safe haven?
It is a low cost option play on the break-up of the Euro.
At the moment the Deutschemark hasn’t been introduced so you cannot buy an option on it. But if in the event that the Euro does break up into its original currencies the it would be a safe bet that all securities would be redenominated in those original currencies at an official exchange rate. So German Bunds would then be denominated not in Euros but in new DM. That is why 2yr Schatz are the preferred security for those willing to take that bet. 1yr BuBills may not be long enough, and 5yr Bonds with a yield of 0.4%, may give up some of the expected currency gains in price depreciation. The bet is that the DM would start to appreciate dramatically against the break-up rate used. Maybe by as much as 20% in the first year.
And whilst the DM could appreciate the whole point of the break-up would be to see the currencies of the Periphery, new Drachma, New Escudo, New Peseta and new Irish Punt depreciate by a similar margin. As such any asset bought in Euros today by a foreign investor in the periphery markets could see its value fall in their base currency by again as much as 20%. And if the purchase is financed in Euro, it would need some negotiations with the lending bank to determine what currency the loan continues in. As of yet there have been no reports of loan agreements having a clause inserted in them dictating these terms, but it will surely start to happen.
And so to US Treasuries– which yesterday saw short positions being covered yesterday. JPM’s Treasury client survey last week showed that active traders were more short than longs. And it would have been these shorts that were caught yesterday. The yield differential to 10yr German Bunds remained pretty constant yesterday at 35bp-36bp. So the US 10yr did benefit from “flight to safety” buyers. 10yr yields closed at 1.624% amid a sharp curve flattening with the 30yr yield falling more to 2.71%, which sees the yield curve now at 109bp. It was 120bp at the end of April. It seems plausible that 30yr yields will see further declines and the differential to fall below 100bp. As I pointed out before the case for QE3 has grown, and whilst I do not expect this to happen in the coming month, the market chatter will certainly grow. What action that will be will need to be seen.
The case for QE3 will be argued more forcibly by the Fed Chairman as commodity prices continue to fall and drive Inflation expectations lower. 5yr Inflation breakevens have fallen 35bp this month alone to be now below 1.75%. There has to be more downside pressure on 5yr Inflation breakevens and it will be when these fall below 1.50% that the deflation fears will really be taking hold. That is when we should see 10yr US yields at 1.50% or maybe even lower. It is in the hands of the commodity markets it seems now.
The Fed’s Beige book ,released June 6th, is now even more important and I would expect to see a much greater emphasis put on deflation then.
The drive to a flatter yield curve is driving historical and implied interest rate volatilities higher. Especially in the longer interest rates. That as of yet hasn’t fully fed through to US Risk markets. US Risk markets are probably benefitting from the view that they are less risky than European or EM risk markets. Latam Sovereign US$ Bonds have widened dramatically as the rise in Implied Volatility has occurred as they used to and should do.
The “safe haven” of Brazil has been broken as well and EM debt spreads look to be driven even wider in coming weeks as the US yield curves flatten.
I am therefore struggling to find any risk assets that even after the recent sell-off look cheap. There may be a short-term relief rally, but trading these days is becoming increasingly hairy with levels of liquidity falling.
So my preferred exposure remains in Government bonds and especially those of commodity linked countries such as Canada and Australia. 10yr Australia moved below 3% overnight and to a yield differential of 127bp over the US. Canada at a pick-up over the US of 61bp in 5yrs and 7bp in 10yrs also continue to look attractive ahead of what will surely be now a troublesome few months for the US economy and Fiscal Budget talks.