By Kevin Muir
I haven’t written about it much lately, as over the past few months the trade has been quite a dud, but I still love owning US notes versus short German bunds.
Going into the end of 2016, there was tons of press as the German bund / US T-note 10-year spread hit the “obscene” level of 235 basis points.
It seemed obscene, but this spread had seen those levels before. Yeah sure, the last time the German bund / US T-note traded below negative 200 basis points I was a 19-year old listening to New Order’s Fine Time on my yellow SONY walkman, but that was back in 1989 – Germany was dealing with the fall of the Berlin Wall and the chaos had thrown German financial markets into a tailspin – so those levels should probably be ignored.
These recent spread wides have occurred in a period of relative economic calm. So maybe the 235 basis points was kind of “obscene.”
Last summer, there was speculation the ECB might get more aggressive in their balance sheet tapering. This caused German bund yields to back up. However, Draghi & Co. surprised the market by refusing to ease up on the gas pedal as much as expected, and in the process, sent short-term Euro rates scampering back to pricing in no tapering. At the same time, the Federal Reserve did the opposite, and actually followed through with many of their threatened rate hikes, sending short-term yields to new highs for this cycle. Both Central Bank actions had the effect of sending the German / US 2-year yield spread to new wides.
Again, this spread had seen this level before, but this time, it wasn’t 1989, but instead 1996.
Regardless of how long ago the different part of the German and US yield curves have last seen these sorts of levels, there can be no denying that we are in an unique period where German yields have been pushed down to extraordinarily low levels versus US rates.
2-year leading the way
All of these history lessons don’t really help us answer the question about where the German / US 10-year spread is headed. Or do they?
Remember last summer’s back up in 2-year German yields? The front end of the German sovereign yield curve might be the tail that wags the dog.
Over the past month, the 2-year German yield has spiked.
Yet so far, there has been no narrowing of the German / US 10-year yield spread like there was during the previous German 2-year Schatz sell off.
I have been patiently waiting for an opportunity to add to my trade, and I think this divergence is the opportunity to short more bunds and buy some US t-notes against the position.
For those traders that want to know the hedging ratio, here is the hedging screen for German 10-year bund futures versus US 10-year t-note futures:
I still think the lows of the spread were made two Decembers ago. I don’t foresee a move back down below negative 200 basis points.
Last year, the beginning of 2017 saw the German / US 10-year yield spread embark on a 100 basis point narrowing. I am hopeful the same pattern will play out in 2018.
And who knows? Maybe this time Draghi will actually follow through with some tapering, and we won’t have to suffer through another summer disappointment.
Thanks for reading,
PS: For those who want to add a little US yield curve steepening to the trade (How to put on a Steepener), buying US 5-year t-note futures versus shorting bunds might be even more adventuresome (or stupid). Here is the position hedging screen for that spread…
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