Jun

19

We have a two year low for the German Bund contract, the second or perhaps biggest futures contract in the world by volume (notional value). What could have changed to make the prospects so bad relative to the past over the next ten year horizon? I note this from a speculative context and seek qualitative insight.

Eastsider replies:

1) There had been a macromeme along the lines of: Europe is behind the US in this economic cycle, and the ECB will have to cut rates soon… Trichet's hawkish talk a couple of weeks ago triggered a stampede unwind of that trade rationale.

2) Reports of massive derivative/structured note plays on the Bund curve likely getting tripped too.

J. Rollert adds:

Inflation is high with a strong currency, yet if it regresses back to mean modestly the inflationary pressures will increase.

Double whammy… to bunds. Also foretells major political battle.

Edward Talisse writes in:

I traded bunds for many years whilst working for the blue shoes in London. ECB chatter is obviously hurting sentiment there but something more interesting is also afoot. The bund curve is close to inverting between 10y and 30y. This is a highly unusual situation in Germany where the curve generally remains steep though various cycles. The rub is the structured product market in Europe, which is absolutely huge. Most interest rate derivative notes are written on the back of a CMS (constant maturity swap) structure. The holders of the notes basically sell volatility to earn above market coupons. The problem is that as the curve flattens, CMS gets absolutely killed. So there is a big demand in Europe right now to get into long dated flattening trades. That means people buy 30y and sell 10y, thus depressing the bund future price. 


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8 Comments so far

  1. David Tyree on June 19, 2008 2:19 pm

    Long Bunds vs. Short PIIGS (Portugal, Italy, Ireland, Greece, Spain) is a common trade on the Euro falling apart.

  2. Anatoly Veltman on June 19, 2008 4:54 pm

    I'm sure this particular speculator inquires not because he intends to join a maturing price trend. One should be aware that multi-month downdraft in price of all US Treasury futures from 2 to 5 to 10 to 30y is accompanied by reduction in the Open Interest across the board, to low levels unseen for over a year. There may be an argument that U.S. financial institutions have been gradually curtailing their (hedging) futures activities. I'd love to hear somebody else's opinion on that. If not for a special factor like that then Open Interest reduction invalidates current price downtrend. I noticed that Eurex Bund Open Interest has also been declining. A live example of Open Interest divergence ("trend non-confirmation") occured earlier today in Crude futures. Price was within 1% of its all-time record this morning, when Open Interest of only 1,321,378 was released by the Nymex. Guess what: this reduction from 1,335,207 on Wednesday's $5 intra-day rally put Crude's total Open Interest figure to lowest since April 2007, when price averaged $65!

  3. George Parkanyi on June 19, 2008 9:03 pm

    Victor,

    It’s a good thing you ask on a Thursday, because my answer would be completely different on a Friday. :)

    I don’t know why bunds are hunds right now, because I certainly don’t believe the EU realistically can RAISE interest rates with their currency already this strong in the face of all the recent economic speed bumps we have all come to know and love.

    But one piece of news that got the spidey senses tingling last week or the week before was that Germany was considering reducing their subsidies for green technology. (My Trina Solar tanked temporarily as a result). As you guys with screen farms all know, alternative energy is strategically huge for the Germans because they don’t have much in the way of oil and gas of their own, and have to import it (much of it from Russia). So what gives in Deutschland if the Germans are even CONSIDERING scaling back on wind and solar - especially with oil at these levels?

    (I love the word “bund” by the way - it sounds like a friendly sausage - “zwei bunds mit sauerkraut, bitte”)

    Cheers,
    George

  4. Mulholland Drive Street Racer on June 20, 2008 11:58 am

    I found Marty Feldstein's suggestion Wednesday in the FT for the Saudi's to float the Riyal or cut the peg to the US dollar interesting. Let's see what comes from the weekend conference.

  5. Nelson Rangel on June 20, 2008 5:37 pm

    Two part answer:1) Investor's psychology changed.2) All other explanations seek to explain why (1) happened.

  6. Craig Bowles on June 21, 2008 11:25 am

    The big moves in bonds historically have been when the central bank is too tight and the yield curve is widening. Germany’s probably like the U.S. where the yield curve corrected and isn’t widening anymore. That’s what changed. The German 10-year at 4.63% is below the combination of inflation and economic growth (using the coincident index). That’s still a recession warning. The ECB should be at 4.75% instead of 4.00% for Germany if in line with growth and inflation for 2008. So, owning bonds has to fight the loose central bank to boot.

  7. Mitchell Jones on June 21, 2008 1:08 pm

    The recent peaks (late March to early April) in the Bund, T-note, LIBOR, gold, etc. coincide very well with the Bear Stearns bailout and the resulting spread of doubts about counterparties, due to fears of hidden OTC derivative exposures. A reasonable explanation, therefore, would be that rising perception of counterparty risk has led to a widespread reluctance to lend, and that the consequent reduction in the availability of funds has exceeded the reduction in demand due to recession fears. We have, in short, a deflationary psychology in place which resembles the situation in the 1930’s, and the fact that the Bund continues to make new lows suggests, at least to me, that the financial system remains in imminent danger of seizing up. If so, the recent deluge of hawkish talk from the Fed, the ECB, and elsewhere indicates that either (a) the responsible authorities are experiencing a rather large disconnect from political reality, or else (b) those statements are just talk, and nothing more.

  8. Mulholland Drive Street Racer on June 22, 2008 1:08 pm

    "A global economy needs a global currency" 

    Robert Mundell
    An Economist Who Matters
    By KYLE WINGFIELD
    June 21, 2008; Page A7 WSJ 

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