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.
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.