European Bond Yields have risen dramatically in the past few weeks with a rout yesterday and it looks to continue today.
This is the price action of the 30yr German Bund down 7 points in 2 days! - Why, what has happened?
It's not as if the market is expecting a positive announcement from the Greek elections as Italian and Spanish yields rose as well. And in the case of Spain to record Euro area levels.
Could it be the Swedish affect? - where the Regulators are talking about relaxing the stifling regulations on Insurance and Pension Funds solvency ratios. Maybe if it was even being mentioned in other markets?
Could it have been supply fears? - There was a €1.7bln tap of the Dutch 2033 and the EFSF launched €1.5bln a 25yr but the auction was covered easily and the EFSF deal was increased in size due to demand.
What about Eurobonds and full federalism? - if that was being priced in then French, Dutch and more importantly Italian and Spanish yields would be converging on German and not widening.
There have been talk of a large fund manager switching out of 10yr and 30yr German Bunds into US Treasuries. This may be partially true, as US Treasuries have outperformed, 10yr German Bunds now yield just 17bp below US 10yrs. It was 35bp last week and with supply in the US I had been expecting this to stay above 30bp.
So I was struggling yesterday to understand what was going on. Then I thought what would happen to a leveraged owner of German Bunds versus other Peripheral Bonds in the event of a Euro break up? Chances are that the Repo and Reverse Repo would be redenominated in the new currency of the underlying Bonds. That would mean that if you owned a 30yr German Bund the Repo would be denominated in New Deutsche Marks and as such you would not gain from any currency appreciation. And the other bond you were short would have its Reverse Repo denominated in its new currency. In that case then there is a reasonable likelihood that 30yr German Bund Yields would rise and as such leveraged longs would lose value.
So with yields of Spanish and Italian government bonds rising again today , 10yr Spain at 6.75%, the Hedge Funds may well be taking the profits now in the Bund market whilst they are sure that they will be redenominated in a currency they want. They are likely to move their 30yr Long bond holdings into the US and UK.
The pain may well continue for real money investors, but in the event of a Euro break up, deflation in Germany will be the greater fear and 30yr Bunds at 2.125% will look a great buy.
But to me it is a trade showing that Investors are becoming more and more concerned of a Euro break-up in the near term.