Keeping It Simple...Bund vs. UST Rates after the EUR rally

As the US continues to slog through a winter marked by one sub-zero reading after another, let’s do some KISS trading--keep it simple, stupid.

Last week the short USD theme went from sideshow to the main stage of the market’s three ring circus. As noted here, the BoJ woke up to the possibility that the economy is perking up quite nicely, and higher global interest rates caused the YCC flows to dry up, leading to news of a “stealth taper”. Well, if you’re strategy is to buy bonds at a certain yield, and nobody shows up to sell them there, you don’t have much to do! So while I wouldn’t put much stock in the BoJ’s pseudo-announcement that they will be buying fewer long end bonds, nor the flatlining balance sheet--the turn in sentiment and momentum is significant. JPY has finally joined the party, and I think we’ll see correlations to G7 FX increase to historic norms until Kuroda and Co. give us a signal about where the asset-purchase scheme is going next. KISS: stay short USD vs. JPY, scandies and selected EMFX until further notice…

And rates….the UST selloff stalled out last week, despite some very good retail sales and CPI data out on Friday. Maybe the higher rates theme is running out of steam? I think that’s a strong possibility--as I noted last week, I think there is more downside than upside for US economic data, even if that doesn’t mean a reversal in Spoos or UST yields. Let's stick with the theme above--a resurgence in economic growth, investment and outright optimism in countries where the word of the decade has been “malaise”.  

Sure, euro-area inflation came out week again, but you can’t ignore this jump in PMI.

And look who shows up at the top of the table: France and three of the four PIGS! This resurgence is broad-based, and dragging along countries with significant excess capacity.

The ECB is starting to make some rumblings about how they can retool their asset purchase program. There are a number of things they can do--but easing up on buying duration seems like a good place to start. EUR-strength will be a consideration--but if this move doesn’t continue towards 1.25 I don’t think it will be a factor.

There still seems like too much complacency in the rates market. You can see in this pic how the correlation to 10y UST has been very strong lately--interesting to note that the correlation early in the year was pretty weak, but is 65% over the past three months.

Yet we saw a big move higher in bund yields late last week driven by the minutes from the last ECB meeting. bunds underperformed UST...which went hand in hand with the strengthening EUR. Given the fundamentals and 10y bund yields still trading inside the highs of last summer, I think yields can continue to move higher from here. I’d be careful with the bund/UST spread since there is a beta component there (if you trade dv-neutral, your long ust/short bund trade can get barbequed on a global move higher in rates) but what I see in the chart here is a spread too cheap given the underlying fundamentals:  there is still value in the market pricing in some combination of higher European rates and monetary tightening.  

Then there are articles like this one, which highlights GMO’s Jeremy Grantham abandoning his value-based principles and thinking about just how far this “melt-up” rally in stocks can continue.

I won’t go into any detail here other than to say this market won’t die of over-valuation. Something will break it. We just don’t know when or why.    

Shawn
TeamMacroMan2@gmail.com
@EMInflationista