Recap 2014-08-14 : Bunds

Commentary:

Ay Caramba! Bund yields broke below 1% today, as EU GDP was flat QoQ vs +0.1% exp and +0.2% prev. Of the 4 major countries, only Spain posted a positive print. The Europe is Japan view is now fairly common thinking. But does this really make sense? Let’s take a step back.

First, let’s take a look at what very long term EU yields are pricing. The chart below shows 30y real yields in white, and inflation swaps in orange. As the chart shows, markets are pricing in BOTH of the following:

  • the ECB will miss its inflation target over the next 3 decades. Historically, the 30y inflation swap rate will price in a premium given the duration. It is now at 2%, a level not seen since the period following the Lehman bankruptcy
  • EU Growth will likely* be zero over the next 3 decades. Or the ECB will eventually conduct a massive Kuroda-style QE. Either way, with real yields at zero – the lowest level since early 2013, when EU breakup fears were widespread – the market is discounting some very weak growth outcomes

Are those scenarios justified? Certainly not. I don’t know of anyone who really thinks the EU will have no growth for 3 decades. In fact the Bloomberg consensus forecast for 2016 EU growth has actually been fairly stable this year, moving between 1.5 to 1.65%:

This suggests that market consensus is likely NOT that EU growth will be zero over the long run. In fact, even Japan had positive real growth during the previous decade.

But let’s assume that the EU will follow a Japan like scenario. What would it look like? Well, some readers may be surprised that 10y JGB yields actually stayed well above 1% for most of the previous decade, outside the Asia crisis and QE periods:

There isn’t much of a long term inflation swap market for JPY assets, but an interpolated rate on the few instruments that did exist showed that even in Japan in the previous decade, short term real yields remained well above zero.

Up until now, EU risk free rates seemed most attractive to pay on a relative basis. Given current pricing, however, they are now attractive enough to pay on an absolute basis.

The trick, as usual, is getting the timing right. And that question – like many timing questions in macro space – may be impacted by the Fed. The chart below shows 10y bund yields vs Fed Funds. Note that historically, two factors have coincided with lows for German yields: Fed hikes and when Fed Funds are higher than bund yields. Those instances are marked by vertical lines below:

Given current trajectories, one or both of those catalysts are likely to occur sometime over the next 12 months. Keep an eye open for low carry ways to pay EU rates. They will eventually – ahem – pay off.

Notable:

  • US Jobless Claims rose to 311k vs 295k exp and 289k prev
  • France Payrolls rose 0.1% in 2Q vs -0.1% exp and prev. Wages rose 0.4% as exp
  • France GDP was flat in 2Q vs +0.1% exp and 0.7% prev
  • Germany GDP fell -0.2% in 2Q vs -0.1% exp and 0.8% prev
  • NZ Mfg PMI was stable at 53 vs 53.3 prev
  • NZ Retail Sales rose 1.2% QoQ vs 1.0% exp and 0.7% prev
  • Wal-Mart cut their outlook: Walmart updated full year EPS guidance to a range of $4.90 to $5.15, from a previous range of $5.10 to $5.45. This range includes third quarter EPS guidance of $1.10 to $1.20. The new full year guidance reflects incremental investments in e-commerce and higher U.S. health-care costs than previously anticipated. h/t Jordan

Upcoming:

  • Fri: UKGDP, US Empire Mfg, PPI, UMichigan Confidence
  • Mon: US NAHB, RBA Minutes
  • Tue: UKCPI, USCPI, US Housing Starts, Building Permits,
  • Wed: BoE Minutes, Fed minutes, Japan PMI, China HSBC PMI
  • Thu: EU PMI, US Jobless Claims, Markit PMI, Philly Fed, Existing Home Sales, EU Consumer Confidence
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