Time to sell the Bund?

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Nicolas Chaput (pictured), CEO & co-CIO Oddo AM and  Laurent Denize, co-CIO Oddo AM comment on the implications of recent turbulences in German sovereign debt markets.

Ten-year German sovereign yields have risen almost 10-fold in just a few days. In other circumstances, a selloff of this magnitude would have triggered a bond crash. Central banks’ zero-interest-rate policies have helped “limit the damage” to about 50bp, which still amounts to a loss of almost 4% from the peak on 10-year bonds and 14% in the case of 30-year bonds.

First of all, the sell-off was probably triggered by an unwinding of QE-linked investment strategies– in this case, profit-taking – which for US investors, for example, consist in closing out their long European bond positions and their hedges against a weakening in the euro.

We feel that the market had become too complacent in recent months, pushing yields to unsustainable levels that were actually below the deposit rate. The macroeconomic improvement in the euro zone and the Fed’s absolute need to restore its leeway in the event of a future slowdown in US growth remind us that, although interest rates may well remain low for another few months, the future direction is up.

Even so, the current movement is likely to be hemmed in by strong technical resistance from ECB asset purchases. Remember that surplus liquidity will continue to increase from its current 297 billion euro level. Yields on short-dated maturities can therefore not widen by very much.

We continue to overweight European equities but will be keeping an eye on the three factors that have driven the recent months’ rally: a low euro, low oil prices and low interest rates. Clearly, these three factors have reversed course recently, but only temporarily.

So an additional asset class must be added to equities: volatility. We feel that interest-rate volatility is steeply discounted. It is possible, for example, to buy volatility on 10-year German yields at 4%. For nonspecialists, 29 April produced volatility of about 16%. So there is room to “realise” volatility at a higher level than the purchase price. Futures and options on futures should be used to implement this type of strategy.

Such instruments are rather complex, so we encourage investors to use funds rather than try to set up the strategy themselves. If this indeed the “opportunity of a lifetime”, it is more safely taken by buying interest-rate options than the outright sale of German bonds at these levels.

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