Free Fallin’: Global Yields Collapse, But Beware The Snapback

It’s a perfect storm. An abysmal NFP print in the US, a worsening outlook for global growth, jitters over whether Britain will vote to leave the EU, and billionaires effectively coming out of retirement to buy gold and make “a bunch of big bearish bets.”

And then there’s the lingering threat that China could simply implode under the weight of trillions in NPLs tucked away and obscured on bank balance sheets.

Lions, tigers, and bears, oh my!

Cue the flight to safety. Investors piled into “havens” on Friday as yields on German, Japanese, and UK 10s collapsed to record lows. The 10Y bund is now flirting with zero.


(Chart: Bloomberg)

Just how prevalent have zero and sub-zero yields become, you ask? As the following chart from Citi shows, nearly half of the entire European government bond market trades at 0% or below.

(Chart: Citi)

That’s more than $3 trillion worth of paper trading negative.

“As more and more bonds necessary trade below -0.40%, they become ineligible for PSPP purchases and as such, QE is focused on higher maturities,” Citi notes, adding that “this induces a ‘rolling flattening’ across EGBs.”

Right, or it “induces” the ECB to consider taking the depo floor even further into negative territory, lest every EGB curve should eventually flatten out completely. The bank is just chasing its own tail further and further into NIRP.

All told, more than $10 trillion in global government debt carries a negative yield. On Thursday, Bill Gross called that phenomenon a “supernova that will explode one day.”

Anyone remember what happened to Gross last spring after he called 10Y bunds the “short of a lifetime?” For those in need of a refresher, recall that shortly after his comments, bund yields did indeed spike, in what certainly looked like a rerun of the 2013 JGB VaR shock. The concept is pretty simple: global QE drives down volatility, so managers simply raise the size of their positions in tandem - and then things reverse. Here’s how JPMorgan put it last summer:

“One of the unintended consequences of QE is a higher frequency of volatility episodes or VaR shocks: investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self- reinforcing volatility-induced selling. This, we note, is how QE increases the likelihood of VaR shocks. “

(Chart: Bloomberg)

Unfortunately for Gross, his call was exactly right, but his execution was poor. Essentially, he didn’t know how right he was about to be.

We won’t bore you with the particulars there, but the important thing to note is that there’s an important lesson in last year’s great bund bloodbath. Namely, that when markets are distorted, corrections can be violent and there’s now $10 trillion worth of distortion in sovereign debt markets. As Rick Santelli put it on CNBC earlier today, “remember, the last time the yield on the 10Y bund was this low, it didn’t stay there long.”

Now that the ECB has officially begun buying investment grade (IG) corporate bonds, you may see the same dynamic show up outside of government debt.
If you can catch one of these moves ahead of time, you can make a fortune.

Spread the love

Comments are closed.