A few weeks ago, the man formerly known as the Bond King, Bill Gross, tweeted that shorting German bunds would be the trade of the century.
I was gratified to see that he was reading my mind, as readers of my Credit Strategist newsletter already know.
As a result of a massive bond-buying program by the European Central Bank (ECB), the yields not only on German bunds but on all European debt had plunged to ridiculously low levels. Here’s what you need to know…
Europe's Negative-Yield Market Threatens Every Nation
Trillions of dollars of European debt were trading with negative yields. Speculators were front-running the ECB knowing that they could buy bonds and sell them back to ECB.
Unfortunately, things didn’t work out quite like they planned. Over the last couple of weeks, German bunds have sold off in one of the biggest bond routs in history. The yield has now spiked up to 0.65%, inflicting big losses on speculators who thought that the ECB would be able to drive yields below zero.
Now you may be asking why you should care about what happens in European bond markets. The reason is very simple – it affects what is happening in U.S. markets.
Indeed, it’s the aftershocks to the stock market that we need to fear the most…
The carnage in the European bond market is widespread.
Yields on Spanish, Italian, and French bonds have all risen by 50 basis points while Portuguese bonds have spiked by 70 basis points. Only Switzerland has seen a mere 20-basis point increase in its 10-year rates to a miniscule 0.07%.
Over the same period that German bunds fell out of bed (at one point hitting a 10-year yield low of 0.05%), the yield on 10-year U.S. Treasuries rose by 38 basis points to 2.22% (and the yield hit an intra-day high of 2.366% on May 11, its highest level in six months).
Treasuries have a strong correlation with German bunds because global investors shop around for the best place to park their money. If rates in Germany drop, it puts downward pressure on U.S. rates. It is probably no accident that 10-year rates in Japan have also spiked up to 0.45%, their highest levels in months.
But there is a bigger picture that investors need to consider.
About $2 trillion of European debt is still trading with negative yield (the actual amount changes daily). This is not only a historical anomaly but also a sign that economic policy is failing and likely to lead the world into another crisis.
Negative yields effectively confiscate capital from bondholders. The only reason to hold such a bond is because the holder believes it will trade to an even more negative yield, therefore generating a capital gain, or because the holder is required to do so to meet capital requirements or other regulatory tests.
But these negative yields are inflicting serious damage on the financial system…
As the Bond Market Goes, So Goes the Stock Market
For example, there are reportedly 3 trillion euros of insurance policies written in Europe that were written when rates were higher. There is no way that these insurance companies can meet these obligations if rates persist at these low levels for a prolonged period of time. Negative yields will slowly erode these companies’ capital bases and threaten their businesses unless the situation changes.
American insurance companies are facing similar, though less severe, stresses as a result of low interest rates in the United States.
But the reason the ECB is engineering a situation where trillions of dollars of short-term debt is yielding less than zero percent is because policymakers refuse to adopt pro-growth policies.
Instead, the ECB is left with a policy that confiscates capital from savers in a desperate attempt to promote economic growth. The problem with this approach is that it can never possibly work – no economy can shrink or borrow itself to prosperity.
Instead, by trying to buy back over 1 trillion euros of bonds over the next 18 months, the ECB is destroying market liquidity by removing these bonds from circulation. As a result, small market moves produce exaggerated price moves as has been evident in the sharp spike in the yields in German bunds. These sharp price moves wreak chaos in all financial markets, not just bond markets.
Sooner or later, what is happening in the bond market is going to affect the stock market. All markets are connected in today’s global economy. Investors who are counting on central bankers to manage growth after years of failing to do so are a living example of the triumph of hope over experience.
Investors should look at what happened to the investors who were counting on German bunds to keep rising (and yields to keep falling) and realize that financial markets don’t grow to the sky even if they are watered by central bankers.
Editor's Note: Bond prices might be entering a period of turmoil, but there are plenty of opportunities for those who know where to look. Get access to our experts' best ideas in Bill Patalon's Private Briefing. Learn more here.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.