Heisenberg Report

‘Shocks’ And A ‘Critical’ Level

We all know the rapid rise in U.S. yields was the proximate cause for the selloff that, as some people seem to have understandably forgotten given the gravity of what happened on Monday, actually started last week, when equities finally had all they could take of the bond selloff and fell in sympathy.

On Wednesday, the bond jitters were back after a lackluster 10Y auction came hot on the heels of a spending bill that looks like it will further increase the deficit and raise Treasury supply. So, yields rose and stocks once again wavered as fears of the bond selloff resurfaced and everyone suddenly remembered that this wasn’t all about XIV.

Well as you ponder this, don’t forget that the selloff in bunds has been pretty damn dramatic too as investors ponder what the beginning of the end of ECB QE will mean amid increasingly upbeat econ data that will likely force Draghi and the doves to make concessions to the hawks although thanks to Steve Mnuchin’s efforts to jawbone the dollar lower, it looks like assuming APP will end completely come September might not be a safe bet.


In any event, here’s what 10Y yields in Germany have done over the past several months:

Again, that’s pretty dramatic and it raises questions not only about the extent to which Europe will contribute to the bearish global rates shock but also about what the spillover might look like for other assets across the pond.

This discussion is particularly interesting because as with most other dynamics in the post-crisis world, traditional relationships might not necessarily apply thanks to QE distortions.

“Bund yields had at some pointed moved 45bp from the local lows; the largest standard deviation move since 1999,” BofAML writes, in a new note out Thursday, before asking the following rhetorical question:

Who would have imagined that when 10yr bund yields reach the highest level in 2.5 years, credit spreads would have been setting new 11-year record tights, totally defying the moves in the rates market?

Here’s the money chart:

So there are a couple of notables here besides the fun chart with the bright red line. For one thing, BofAML reminds you that “before the introduction of QE the typical relationship between rates and spreads has been a negatively correlated one: the lower the yield the wider the spreads highlighting the accommodating policies from central banks to battle a downturn, that consequently demand wider credit spreads, [while] in periods characterised by stronger growth and higher inflation, government bond yields tend to increase and credit spreads tend to tighten.”

Ok, but now there’s QE and as we (and pretty much everyone else who watches this shit) have variously noted, CSPP looks to be shouldering a disproportionate shares of the taper burden for the ECB. So if you’ve got flows into credit funds and a persistent technical from an ECB CSPP bid, you’re likely to get tighter spreads in the absence of a supply avalanche. Well check this out:

“Despite the ECB third tapering phase, the CSPP turns to be the X-factor of the QE program,” BofAML continues, adding that “currently the CSPP is the vehicle to accumulate around a quarter of the assets needed under both the credit and the government programs combined; note the significantly change in trends seen since the start of this year.”

Meanwhile, the ECB has thus far been able to have their cake and eat it too. They’ve succeeded in moving further down the road towards normalization without triggering a dramatic rise in rates vol., and for anyone who has been paying attention for the past three months, one of the biggest risks to markets is a dramatic rise in rates vol. That’s why “sudden increase in inflation” is at the top of everyone’s “biggest worry” list and on that score, you might recall that last week’s PMI data out of Europe certainly seemed to suggest that price pressures are indeed building. Take a look at this chart:

In this respect, Mnuchin’s dollar comments were probably a blessing, to the extent they give the ECB an excuse to remain dovish (too much hawkishness risks catalyzing still more euro strength thus raising the specter of an FX-related disinflationary shock). Here’s what BofAML has to say on that score:

With the euro steadily appreciating vs. the dollar on the back of strong economic sentiment in the euro-area, it is hard for the hawks to keep pushing for a faster  tightening of the monetary policy as inflation is still hovering at the 1% area and has failed to break above 1.2% since 2013. Put that on top of the recent market turmoil in the equity market and it feels that it is not very likely the ECB will be becoming very hawkish anytime soon.

So when does rate rise become a problem for credit in Europe? Well, the short answer according to BofAML is simply this: when rates vol. moves above 50. Here’s the chart on that:

Of course one certainly imagines that in the current environment, a scenario where rates vol. spikes to what BofAML calls the “critical for credit” threshold, it would be curtains for equities.

Again: nowhere to hide in a bond selloff that’s violent enough to push up rates vol.