No respite for German Bunds

By: Seven_Days_Ahead

The safe haven days of the Bund are clearly in the past. After the frenetic buying that peaked in August, the Bund has been on a clear trend lower and it hasn’t been alone.

But given the Eurozone sovereign debt crisis still remains a live issue, and it was that very crisis that sent the Bund and other Bond markets soaring on safe haven trading, what has changed?

The Technical Trader’s view:

The Macro Trader’s view:
The safe haven days of the Bund are clearly in the past. After the frenetic buying that peaked in August, the Bund has been on a clear trend lower and it hasn’t been alone.

But given the Eurozone sovereign debt crisis still remains a live issue, and it was that very crisis that sent the Bund and other Bond markets soaring on safe haven trading, what has changed?

There are several factors now at work, but these are the key dynamics driving the market:

1. The growth outlook for the world economy continues to look positive, but whereas earlier last year growth was driven mainly by China and India, the Euro zone and the US are now contributing, and
2. The threat of inflation globally has become a real concern in both the large emerging economies and the developed.

Staring with growth, the Eurozone economy has performed well considering the hysteria generated by the debt crisis last year. Indeed there was a real fear that the Euro zone wouldn’t survive in its current form and the real economy would take a hit. It didn’t.
Germany acted as a corner stone for the Euro zone rescue fund. And her economy continues to power ahead aided by the French which together make up at least 40% of Euro zone GDP, masking the weakness of the peripheral states that continue to struggle.

Additionally, the US economy, moribund for so long, has finally woken up. The Fed remains concerned enough to stick with its QE2 program, but also acknowledges an improvement. However, the US remains wedded to a fiscal policy that is building a huge mountain of debt, fast approaching 100% of GDP, and although the Euro zone has rescued several of its weaker members through the rescue fund, the total amount of debt in the Euro zone remains unchanged; just redistributed.

Then there is inflation. The fiscal pump priming employed by the G20 saved the world from a financial market meltdown and depression, but unlike the UK, the US and Japan are still supporting their economies through expansive fiscal policies that longer term are unaffordable.

The US President has a liberal agenda requiring massive public spending, which isn’t going down too well with the US public, hence the midterm election results that saw the Republicans do well. Japan remains in the grip of a deflation that policy makers there seem unable to shake off.

Additionally, the Fed, Bank of England and Bank of Japan have resorted to quantum easing to help re-inflate their economies. But higher inflation is the likely price. In the US inflation remains broadly contained and Japan is grappling with deflation, but the Euro zone CPI rate is now above the ECB’s target and the UK has experienced CPI inflation well above the official target for a prolonged period. The economies of China and India are also at risk of overheating and the authorities there are tightening policy.

Both the Bank of England and the ECB have started to sound more hawkish about inflation in recent weeks and this has unnerved the markets, especially the Bund and Gilt.

But where is the trigger that could send bonds lower?

Yesterday the S&P credit rating agency downgraded the Sovereign debt rating of Japan for lacking a credible plan to reduce its deficit and control the National debt (well in excess of 100% of GDP).

For a long time traders assumed, as did we, this didn’t matter. Japan has large currency reserves, runs a trade surplus and domestic buyers are the main investors in JGB’s, but it appears Japan has reached a level of public indebtedness that make its credit rating unsustainable.
If Japan’s rating can be cut, the Euro zone and the US other two look very vulnerable and bonds no longer look safe.

Mark Sturdy
John Lewis

Seven Days Ahead
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