The Eurostoxx outperformance of the past month has garnered a lot of attention, but there is another similar trade many investors are missing. Not only that, but it has a positive carry, something that is sorely lacking in this day and age of NIRP.
Since early April, the German Bund / US T-note 10 year yield spread has rallied 35 basis points, rising from negative 220 bps to 185 bps.
For all those who think quantitative easing is long end fixed income friendly, this move makes no sense. After all, the ECB is busy buying bunds by the bucketful while the Federal Reserve is preparing the market for the eventual winding down of their balance sheet, reducing the rate of reinvestment (and therefore bond buying). Yet, for me, this move makes complete sense. What is a bond investor’s worst nightmare (after default)? Inflation. What is quantitative easing suppose to create? Inflation. Why then does the market expect QE to cause bond prices to rise? If Central Banks are successful, it should actually create the exact opposite reaction.
Of course, it’s not quite this simple, and no doubt the rate of private sector money creation greatly influences the extent of the inflation created by the Central Banks’ quantitative easing, but fixed income investors shouldn’t cheer when Central Banks write blue tickets.
But let’s step back and think about the current European / US situation. The ECB is the second easiest Central Bank out there (right behind the BoJ), while the Federal Reserve the most hawkish. It might take a while, but eventually, these policies will filter through to the real economy.
And it looks like it might finally be happening. Have a look at the CitiBank Economic Surprise index for both the EU and the US:
US economic performance versus expectations has plummeted, while Europe is hanging in there at lofty levels.
If you are a big US economic bear, you could try shorting stocks. But I would much rather own US fixed income against being short German bunds.
Even though the 10 year German bund / US t-note spread has backed up 35 basis points over the past couple of months, it is still sitting at extremely depressed levels.
While you wait, you earn the monster positive carry.
This has long been one of my favourite trades, and even though it has moved my way, I am not taking any off. In fact, now that it is working, I probably should be adding…
PS: For those who don’t have access to a Bloomberg or similar bond calculating program, here is the Position Hedging screenshot for the Eurex Bund future vs. CME US 10 Year T-note future. It is almost 2 TYM7 for each FGBLM7.