Bill Gross was the darling of “access media” for promoting his favorite trade (what he called the short of a lifetime), the German bund. It captured the headlines on financial blogs but it is the wrong trade. If an investor wished to trade the “short of a lifetime,” the more appropriate tool would be the FRENCH OAT (the name for the French 10-year bond). It seems that Gross’s logic is based on the fact that the German BUND can only drop to -20 basis points because the ECB has determined that it will not purchase sovereign debt yielding less than its official reserve rate so over the time the BUND has a ceiling on its potential value. Gross is making the case that the ECB has so badly distorted the sovereign debt markets through its QE program that valuations are badly misaligned, BUT THE FRENCH OAT IS MUCH MORE OVERVALUED.
Yes, German growth is far outpacing the rest of the eurozone, thus the ECB’s interest rate is wrong for the German economy. This is going to be a political problem for Brussels as the German citizens are going to become disenchanted with receiving ultra-low interest rates on their savings in a high growth economy–the paradigm of financial repression. The French growth story is tepid at best and while French sovereign debt yields 27 basis points more than German bunds the slight differential is not worth the risk of France’s structural problems.
The following chart, courtesy of Bloomberg, will show the vast difference between the German and French budgets. Germany has a slight SURPLUS while FRANCE has a sizable deficit. The problem is further compounded for shorting the BUND rather than the OAT because the German debt is considered to be the highest form of collateral for operating in the European REPO MARKET and thus will continue to be in demand by the financial system. Also, because Germany maintains a massive trade surplus and France a significant deficit, the minimal spread between German and French yields renders the French 10-YEAR OAT the true short of a lifetime.
Now, economic logic would dictate that the BUND should depreciate far more because of its GROWTH story but because the ECB has broken the European sovereign debt markets through its intervention all assigned values are meaningless. However, I will add a very important warning to those model builders of econometric risk. IF THE EUROZONE AND EURO WERE TO DISSOLVE, GERMAN YIELDS WOULD RISE IN RESPONSE TO THE REAL GERMAN ECONOMY. WITHOUT THE GOOD CREDIT OF THE BUNDESBANK, THE FRENCH AND OTHERS THEN WOULD BE SADDLED WITH THE THREAT OF SOLVENCY RISK AND RATES ACROSS THE EUROPEAN PERIPHERALS WOULD SOAR, INCLUDING FRANCE WITH ITS LARGE TWIN DEFICITS. For proof, look back to the financial markets in July 2012, before Draghi’s “whatever it takes” speech.
The bottom line is Bill Gross is right. Debt levels are mispriced because of the ECB but it is the French oat that is the most egregiously overvalued. The problem for traders is that the ECB‘s 60 billion euro bond buying program has the ability to distort every bond market on any given day. If it runs out of bunds to buy, the ECB resorts to purchasing all the others. I hate to be cynical but the ECB sets the price of everything and the value of nothing. If the German people acquiesce to transferring large sums of money to support all the debt plagued European states then the German bund will be the greatest short of a lifetime, but the Bundestag providing the vast amount of funds will not be in our lifetimes.
***Quick hitters from the weekend:
1. ECB President Mario Draghi commented from the IMF meetings. He said, “It’s pointless to go short the euro.” It seems that Draghi believes that the eurozone is getting its house in order as it experiences, “… growth, fairness, fiscal sustainability and financial stability.” It amazes that Mario Draghi is now confident of a quick European rebound. The DAX and CAC have sustained sizable rallies as foreign investors have found European stocks valuable in a negative interest rate environment. Also, the 20 percent drop in the EURO has caused investors to believe that European corporations will sustain a competitive edge due to the weakened state of the EURO. Maybe being SHORT the EURO hasn’t been pointless.
2. IMF Director Christine Lagarde was reported to have said, “… the Fund will not countenance a moratorium on debt repayments.” In an Ambrose Evans-Pritchard article in the London Telegraph–“Greek Crisis Deepens As IMF Shoots Down Hopes For Payment Relief”–Lagrade is quoted: “We have never had an advanced economy asking for payment delays. It is clearly not a course of action that would be fit or recommended. This would mean additional contributions by the international community and some of the countries are in a direr situation than those seeking the delays.” Lagarde also said “… she will inform Mr. Varoufakis about ‘precedents and history’ of the IMF’s process, alluding to the semi-sacred status that the FUND expects to enjoy as the world’s lender-of last-resort.”
This is all nonsense and shows that Director Lagarde has no respect for the democratic process, for the Greek citizens have voted to say they care nothing about precedents and history. The world is dynamic except when it comes to the IMF coffers. In answering the question about Lagarde’s concern for additional contributions, it is time that the IMF utilizes it GOLD HOARD by monetizing it. Again, take the GOLD and offer GOLD-BACKED IMF BONDS to global investors, so it’s not violating IMF covenants and liquefy a static reserve. It boggles my mind that a KEYNESIAN-based institution such as the IMF cannot find a creative use for the notorious BARBAROUS RELIC.
The issuing of GOLD-backed debt would provide the funds that the IMF claims it needs to deal with a growing global financial system. I am sure that the Chinese authorities would be very happy to swap U.S. dollar reserves for IMF GOLD. IMF GOLD-BACKED BONDS COULD OFFER A 2% YIELD AND A GUARANTEE OF TWENTY GOLD IF THE DEBT GOES INTO ARREARS. NOW THAT IS A BOND NOT TO BE SHORT.
Tags: Christine Lagarde, ECB, Euro, Europe, Eurozone, France, French oat, German bund, Germany, Gold-backed bonds, Greece, IMF, Mario Draghi, QE
April 21, 2015 at 8:30 pm |
Read yra s post! Remember I called this trade before ANY of these “genius’s”. Lmao
Sent from my iPhone
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April 22, 2015 at 1:03 am |
Hi Yra I’m with you in preferring oat short v. bunds, in the break up scenario you could suddenly find your self short DM’s, so even if bund yields go up, the price of the bunds in USD may go dramatically up not down. The potential currency volatility lies hidden at the moment, but surely you consider wing scenarios for the “trade of a life time”?!
April 22, 2015 at 5:31 am |
Kevin–yes the currency volatility will be great but it makes the French decision ultimately more difficult–does the French cleave to a D-Mark r to the southern states weaker currency???
April 22, 2015 at 7:19 am |
Mr Draghi might be right about the upcoming improvement of the eurozone’s economy( as a whole) ,though it doesn’t mean that the Euro cannot go any lower in the coming months. What we know from the history is that as long as there is no panic regarding a currency- and hundreds of millions of people use Euro pretty confidently now- then an increase in supply of such currency must eventually bring about increased production and consumption. Sure that without other changes( to free the markets) this will be all short lived and in accordance to Austrian School of economics the longer it goes on the worse depression will come. The politicians don’t care about tomorrow because the public don’t understand economics and a lag in outcome when the economic ”rules” are changed. Whoever would like to see a disintegration of Euro will have to wait for a depression which inevitably will come after a present credit expansion by ECB. Only then the public’s mood will change, right now the state debts or transfers of wealth through currency manipulation and tender laws are so abstract to many that they don’t bother- how else to explain a 10trillion more of debt of the US state and all the talking of ”improved economy”. Well, give me a 10trl USD and I can show you a good time.
Before the Euro disintegrates we could as well see a freely floating Chinese currency – and that would be a big impact on Euro and US dollar value.
At the end what I would advocate and what would be great for human kind and not just ruling classes is to repeal tender laws and allow competition in money and free banking so that no grand manipulation over billions of people would happen- as it happens now in a centralized-socialist monetary systems around the globe.
April 22, 2015 at 9:36 am |
First, I have no likely opportunity to “Beat the Dealer” and bet against either the Bund or the OAT. That said, I think part of Gross’ thinking is that the Bund carries less risk of default, so at least it will be there when price fall. What is worse is that I woke up at 4:50 a.m. thinking about calculating the odds somehow as though I were playing the Bund as a blackjack hand… eegads!
Re: IMF. I have little regard for Legarde and less for the institution. However, I’d buy some of those gold-backed bonds..
April 22, 2015 at 10:22 am |
Yra- I think the IMF should keep it’s hands on all it’s Gold, and should buy more.
To me, the economic picture is unclear, other than the fact the QE and ZIRP are creating “La Grande Bubble”.
As the only relatively liquid financial instrument with no counterparty risk, I think it would be foolish to pledge it, just in case a crisis hits.
April 22, 2015 at 11:11 am |
Shocked–if you believe their research and jabbering there is no need to worry.The IMF is in some trouble now because of their involvement in the European debt crisis–why do you suppose a former French finance minister who is a lawyer in Chicago was given the job???
April 22, 2015 at 11:53 am |
Yra- With ZIRP and QE completed, they have no bullets (other than Gold), if the economy turns down, soon.
The Budget deficits of G20 countries will go through the roof, with any kind of a decent recession, and their sovereign debt will suffer a downgrade (as you pointed out in the case of OATS).
I believe I saw CL scalping in the SPOO pit in 1982, which makes her well qualified to run the IMF (she knows where the stops are).
April 22, 2015 at 12:38 pm |
Shocked–nice.You are probably right as she was managing DSK’s money–ha.All the models say GOLD has no value–see Bernanke and Buffet
April 22, 2015 at 9:18 pm |
yra,
I thought Gross was emphasizing that negative nominal yields result in free shorts so long as bond yields don’t keep falling, the only question being what the repo cost would be if bunds trade special? French oat yields look to be 0.42 on 10y while German bund are 0.17 on 10y, if the 10y yield falls below the repo rate (not sure where to see this) I believe that makes I essentially a free short? the cost of carry is the prohibitive reason for avoiding shorting fixed income even at these low yields, once yields rise however the back end will get walloped.
April 23, 2015 at 5:08 am |
‘Eurozone is not viable… The policy makers are very committed to keeping the show on the road. Too many people have underestimated the commitment of policy leaders in Europe to try and ensure the project is successful, but ultimately I think economics has a habit of overruling politics.’ Neil Woodford
April 25, 2015 at 5:55 pm |
http://www.advisorperspectives.com/dshort/updates/NYSE-Margin-Debt-and-the-SPX.php
When seeing stories like this it takes me back to having no money in my account at the Merc thinking the next trade would did me out. It all relates to these easy money policies. The machine needs to keep getting greased to keep it going BUT one day things are going to change and get real exciting.
April 26, 2015 at 4:30 am |
Rob Syp–interesting research and certainly confirms what some wise voices are saying–let’s see if the Fed has the gujones to riase margin rates to constrain exuberance for we know that monetary policy to effect equity values is “too broad a tool” except when you are trying to incite a portfolio balance channel–wonder if the Fed has any macroprudential tools in its box
April 26, 2015 at 4:42 am |
great article. Well researched and nicely written. I would however like to add three points which you have not thought of which may change your understanding of why Mr gross is targeting Germany and not France.
One: Mr gross is taking this short as a long term trade, and will likely hold this short until at least 2017 and beyond. Now as he is shorting Germany. Most maturities upto 7y are in negative yield territory. In essence by shorting German debt is will be effectively be receiving cash flows for the next few years and issuers of debt are now paid to issue debt( opposite of normal when issuers pay holders coupons). So effectively it is a positive carry trade Mr gross is playing. He will also likely keep reinvesting what he receives further along the curve as rates become more negative as result of Ecb. Now you won’t see the same yield opportunity in French curve hence one important reason why he is targeting Germany.
Two: Mr gross knows it is very likely that German yields will remain supressed into at least 2016/2017 with inflation not forecast to move. With the ECB effect Germany will remain the pick of investors well ahead of France and the rest but only upto a certain point(negative 20bp) which Ecb has now imposed on European bond markets. However as supply becomes sapped up in German, institutions will move where there are available bonds and next bet is France and then the other core nations before moving to periphery. Mr gross is effectively placing a bet that German yields have little further room to move which makes calculating his risk easy. With huge upside. No doubt France will become a better bet for all the reasons you allured to but not just yet.
I hope this helps!
Well written!!!
December 21, 2016 at 5:29 am |
Reblogged this on Notes From Underground.
January 22, 2017 at 8:36 pm |
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