Are Bunds (German 10-year bonds)(EUREX:GG.C) leading world fixed income prices higher? Going by the past couple of days, it would certainly seem so. Bund yields dipped below 1% last Thursday. Helped by escalating geopolitical tensions between Russia and the Ukraine, they are making another run for it. It is very difficult to fight the fundamentals behind surging Bund prices; the European Central Bank (ECB) has also stated that it is more “dovish” than the U.S. Fed, meaning that they plan on staying very accommodative going forward. Fear of disinflation and the economies slowing in Southern European countries may be bleeding into Germany, potentially thwarting its stabilizing role as the backbone of the European economic recovery. Looking at the Euro, the currency market seems persuaded of the ECB’s dovishness, with the Euro trending lower and breaking key psychological support levels at 1.350 and 1.340 with relative ease. In the United States, the market mantra “Don’t fight the Fed” has been very meaningful given the distorting effect of interventionist monetary policy on “normal” market patterns; it would appear that the same can now be said about the ECB.
Still, the U.S. and the Eurozone economies are at different points in their economic cycles: while the United States has begun the process of exiting its Quantitative Easing (QE) program that has been in place for years, the ECB is merely hinting at taking a more aggressive stance. However, implementing interventionist monetary policy is inherently more complicated in Europe, owing in large part to the fact that the Eurozone alone is made up of 18 independent sovereign member states. One would think that continuing deteriorating economic conditions in Europe would, however, force the ECB to act.
Fixed income markets around the world are also pricing in ongoing and potentially worsening geopolitical tensions. However, at present, it is difficult to say with certainty how much risk has already been priced in but if the relatively low volatility levels are anything to go by, it is not as much as one would, perhaps, think.
The technical picture has both bunds (German 10-year futures) and US 10-year futures(CBOT:TYU4) entrenched in a bullish trend; the same can be said about U.S. Bonds (30-year futures)(CBOT:USU4). Going by the “Don’t fight the Fed/ECB” approach, the logical move would be for market participants to go long bund futures or employ a bullish options on futures strategy and sit back but things are hardly ever as easy as that. Taking this a step further, investors could also spread a long bund position against U.S. 10-year or 30-year futures, heeding the fact that the Fed has already begun its exit program while the ECB is only in the early stages of potentially enacting a QE program of its own.
The below chart shows the September 2014 bund and the U.S. 30-year bond contracts. Taking into account duration and currency differences, the two contracts trade at a ratio of 1.062 for the 30-year Bonds to 1.0 for the bunds - close enough to trade them 1 to 1. The ratio of Bunds to US-10 years is 2.15 to 1. The chart highlights the close correlation between the Bunds and 30-year bonds (1 to 1) over time. A closer look at the chart also shows that from March of this year through June, it was the 30-year that led the way higher after which the bunds took over. This makes sense in light of the messages both the Fed and the ECB have been communicating. And if the status quo is anything to buy the fixed income markets will continue to pay close attention to Fed and ECB communications which, in turn, are shaped chiefly by economic developments in the United States and Eurozone.
Source: Bloomberg. Chart shows German Bund 10-Year Futures and US 30-Year Bond Futures.