What Risk??


By Victor Adair & Drew Zimmerman

Sovereign bonds yields of the peripheral European countries (that’s the current polite term – they used to be called the PIGS) have been falling sharply (prices have been rising) since mid-2012 when the head of the European Central Bank, Mr. Draghi, declared that he would do “Whatever it takes” to save the Euro. Spanish 5 year bonds were yielding nearly 7% in 2012, today the yield is near 1.75%! That is a HUGE move in the bond market… and of course Government bonds can be bought on margin. Anybody who bought Spanish bonds two years ago and still owns them has made HUGE (unrealized) profits! Adding to the fun, the Euro has gone up about 15% against the US Dollar during that time. So if a US Dollar based hedge fund had bought Spanish Government bonds on margin they would have made the trade of a lifetime!


But the real shocker is that Spanish 5 year bonds now yield less that 5 year US Treasuries… implying that Spain is a better credit risk that the USA.

Spanish unemployment is running around 25%…for people under 25 years of age the EU rate is around 53%. A better credit than the USA? But be fair the real yields (coupon yield minus the inflation rate) shows Spanish bonds with net higher yields…because they have deflation in Spain. And further (to be fair) American 5 year bond yields have been rising for the past year (and just hit 3 year highs) as the Fed is winding down, tapering, their asset purchases. But still…where is the arbitrage? How can Spanish bonds yield less that American bonds?

Remember in late 2012 we talked about how the Spanish Government was ploughing nearly the entire Government Employee Pension fund into Spanish Government bonds and it seemed that nobody else wanted to buy them? We thought this was a reckless act by the Government… well, maybe they had some real “We’ve got your back” promises from the ECB? If there is someone out there big enough to buy those bonds the pension fund would register a HUGE profit!

Remember also that the Chinese and the Japanese were buying distressed Euro bonds in 2012 and it looked like they were doing a quid pro quo to maintain trade flows with Europe but maybe they understood that the ECB had their back too.

The rally in the peripheral European bonds has been on expectations that the ECB will (have to) do some sort of Quantitative Easing like Japan and America have done and this will involve buying bonds. The big profits with the assumed ECB “We’ve got your back” guarantee have generated HUGE momentum in this trade.

The fantastic rally in PIGS bonds is also another aspect of REACHING FOR YIELD and at this point (to paraphrase the country music song) IN ALL THE WRONG PLACES.

Where’s the trade?  Given that markets can remain irrational far longer than we can remain solvent, I can’t pick the end of an extremely powerful trend that seems to be going parabolic. BUT the wildness in credit spreads means that

We like the US Dollar Vs the Euro

We like buying Treasuries and selling junk

We like buying Treasuries and selling the stock market.



avatarVictor Adair - Empty posted Monday, April 7th, 2014.

1 Comment for “What Risk??”

  1. I understand EU6 Euro FX is Euro FX Futures (CME Globex) but can you please explain what ratio USA / EP Daily Continuation is a symbol for?

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