Last week we talked a lot about the German bund yield, the most important market in the world right now. Today we want to talk about how to trade it.
The best investors in the world love asymmetric bets (limited downside and virtually, if not literally, unlimited upside). That’s the true recipe to building huge wealth. And there is no better asymmetric bet in the world right now than the German 10-year bund.
With that in mind, in recent weeks, we’ve revisited Bill Gross’ statement last year, when the 10-year government bond yields in Germany were flirting with zero the first time. He called it the “short of a lifetime” to be short the price of German bunds – looking for yields to bounce back. It happened. And it happened aggressively. Within two months the German 10 year yield rocketed from 6 basis points to over 100 basis points (over 1%). But even Gross himself wasn’t on board to the extent he wanted to be. The bounce was so fast, it left a lot of the visionaries of this trade behind.
But over the past year, it’s all come back.
Is it a second chance? German yields are hovering just a touch above zero — threatening to break into negative yield territory for one of the world’s most important government bond markets.
As we said on Friday, the zero line on the German 10-year government bond yield is huge psychological marker for perceived value and credibility of the ECB’s QE efforts. And that has huge consequences, not just for Europe, but for the global economy.
Given the importance of this level (regarding ECB credibility), it’s no surprise that the zero line isn’t giving way easily. This is precisely why Bill Gross called it the “short of a lifetime.” With that, let’s take a look at the incredible risk/reward this represents, and a simple way that one might trade it.
There is a euro bund future (symbol GBL) that tracks the price of the German 10-year bund. Right now, you can trade 1 contract of the German bund future at a value of 164,770 euros by putting up margin of 3,800 euros (the overnight margin at a leading retail broker). If you went short the bund future, here are some potential scenarios:
If you break the zero line in yield, the euro bund future would trade up to about 165.50 (it currently trade 164.77). If you stopped out on a break of zero in yield, you lose 730 euros (about $820 per contract). If the zero line doesn’t breach, and yields do indeed bounce from here, you make about 1,500 euros for every 10 basis point move higher in the German 10-year bund yield.
For example, on a bounce back to 32 basis points, where we stood on March 15th, the profit on your short position would be about 4,600 euros (or about $5,200). If German bund yields don’t breach zero and bounce back to 1%, where it traded just a year ago, you would make about 15,000 euros ($16,900) per contract on your initial risk of $820 – a 20 to 1 winner. Of course, there are margin costs to consider, given the holding period of the trade, but in a zero rate world, it’s relatively small.
If you’re wrong, and the German 10-year yield breaches zero, you’ll know it soon.
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On Wednesday we talked about the most important market in the world, right now. It’s German bunds.
The yield on the 10-year German bund had traded to new record lows, getting just basis points away from the zero line, and thus from crossing into negative yield territory for the 10-year German government bond. That has inched even closer over the past two days, touching as low as 1 basis point today.
Not surprisingly, stocks sold off today. Volatility rose. Commodities backed off. And the broader mood about global economic stability heads into the weekend on the back foot. For perspective, though, U.S. stocks ran to new 2016 highs this week, and are sniffing very close to record highs again. Oil and commodities have been strong, and the broad outlook for the economy and markets look good (absent an economic shock).
What’s happening? Of course, the vote that is coming later this month in the UK, on whether or not UK citizens will vote to ‘Stay’ in the European Union or ‘Leave’ continues to bubble up speculation on the outcome. That creates uncertainty. But the real reason rates are sliding is that the European Central Bank is in buying, not just government bonds, but now corporate bonds too. The QE tool box has been expanded. That naturally drives bond prices higher and yields lower. But the question is, will it translate into a bullish economic impact (i.e. the money the ECB is pumping into the economy resulting in investing, spending, hiring, borrowing). As we discussed on Wednesday, it’s the anticipation of that result that sent rates higher in the U.S. when the Fed was in, outright buying assets, in its three rounds of QE.
With that, the most important marker in the world for financial markets (and economies) in the coming days, remains, the zero line on the German 10-year government bond yield. Draghi has already told us, outright, that they will not take benchmark rates negative (as Japan did). That makes this zero line a huge psychological marker for perceived value of the ECB’s QE efforts.
With this in mind, we head into a Fed meeting next week. The Fed has done its job in managing down expectations of a hike next week. With that, they have no risk in holding off until next month so that they can see the outcome of the stay/leave vote in the UK. And, as we’ve discussed, the Bank of Japan follows the Fed on Wednesday night with a decision on monetary policy. They are in the sweet spot to act, not only to reinvigorate the weak yen trend and strong stock trend in Japan, but to add further stimulus and perception of stability to the global economy. We think we will see that happen.
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On Tuesday we talked about the quiet bull market in commodities. Today we want to talk about one specific commodity that has been lagging the sharp rebound in oil, but is starting to make a big-time move. It’s natural gas. And this is an area with some beaten up stocks that have the potential for huge bounce backs.
Natural gas today was up almost 6% to a six month high. The U.S. Energy Information Administration said in its weekly report that natural gas storage rose less than what analysts had forecast. But that was just an extra kick for a market that has been moving aggressively higher in the past NINE days (up 37% in nine days).
Now, we should note, nat gas is a market that has some incredible swings. Over the past three years it has traded as high as $6.50 and as low as $1.64.
For perspective on the wild swings, take a look at this long term chart.
You can see we’re coming off of a very low base. And the moves in this commodity can be dramatic.
Three months ago natural gas was continuing to slide, even as oil was staging a big bounce. But natural gas has now bounced 58% after sniffing around near the all-time lows. Meanwhile, oil has doubled.
Based on the backdrop for oil, broader commodities, the economy we’ve been discussing, and the acknowledging the history of natural gas prices, we could be looking at early stages of a big run in nat gas prices.
Summer is one of the most volatile periods for natural gas with the combination of heat waves, hurricanes and potential weather pattern shifts such as La Nina. During the summer months, a 50% move in the price of natural gas is not uncommon. Another 50% rise by the end of the summer would put it around $4. And four bucks is near the midpoint of the $6.50 – $1.65 range of the past three years.
Billionaires investor David Einhorn has also perked up to the bull scenario in nat gas. In his most recent investor letter his big macro trade this year is long natural gas. Here’s what he had to say: “Natural gas prices are not high enough to justify drilling in all but the very best locations. The industry has responded by dramatically reducing drilling activity. As existing wells deplete, supplies should fall. The high cost of liquefying and transporting natural gas limits competition to North American sources. Current inventories are high following a period of over-drilling and a record warm winter. However, the excess inventory is only a couple percent of annual production, which has already begun to decline. Normal weather combined with lower production could lead to a shortage within a year.”
This all contributes to the bullish action we’re seeing across commodities, led by the bounceback in oil. The surviving companies of the energy price bust have been staging big comebacks, but could have a lot further to go on a run up in nat gas prices.
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We’ve talked about the bullish technical break occurring in stocks. That’s continuing again today.
Remember, a week from this past Friday we talked about the G7 (G8) effect on stocks. We stepped back through every annual meeting of world leaders since 2009. And the results were clear. If the communiqué from the meetings focused on concerns about the global economy, stocks went higher. It’s that simple.
Why? In the post Great Recession world, stocks are the key barometer of global confidence. Higher stocks can help promote economic recovery (better confidence, higher wealth effect). Lower stocks can derail it, and threaten a bigger downturn, if not fatal blow to the global economy.
Policymakers can and do influence stocks. And thus, when we’ve seen clear messaging from these meetings about global economic concerns, stocks have done well (in most cases, very well).
With all of this said, on May 27th, from the meeting in Japan, the G7 issued their communiqué and it started with global growth concerns. They said, “Global growth is our urgent priority.” The S&P 500 closed at 2099. Today it’s trading 2116 and is closing in on the all-time highs set in May of last year (less than 1% away).
Now, we talked in past months about the importance of Europe. The Fed’s best friend (and the global economy’s best friend) is an improving economy in Europe. We’ve seen some positive surprises in the data out of Europe, but the actions taken this morning by the ECB could be the real catalyst to get the ball rolling — to mark the bottom, to get Europe out of the slow-to-no growth, deflation funk.
They ECB started implementing a new piece to its QE program today. Of course, they promised bigger and bolder QE back in March (mostly as a response to the cheap oil threat). Today they started buying corporate bonds as part of that ramped-up QE plan.
With that, this is a very important observation to keep in mind. Over the history of the Fed’s three rounds of QE, when the Fed telegraphed QE, rates went lower. When they began the actual execution of QE (actually buying bonds), rates went HIGHER, not lower (contrary to popular expectations). Why? Because the market began pricing in a better economic outlook, given the Fed’s actions. We think we could see this play out in Europe as well.
Take a look at this chart of German yields. This is probably the most important chart in the world to watch over the next several days.
The German 10-year yield traded as low as 3 basis points (that’s earning 30 euros a year for every 100,000 euros you loan the German government, for 10 years). Of course, the most important visual in this chart is how close the German 10-year yield is to zero (the white line), and then negative rates.
Remember, we’ve said before that Draghi and the ECB have made it clear that they won’t cut their benchmark rate below zero. And “that should keep the 10–year yield ABOVE zero.” Were we right? We’ll find out very soon. If so, and if German yields put in a low today on the “actual execution” of the ECB’s new corporate bond buying program, then U.S. yields would be at bottom a here too.
You can see in the above chart, it’s a make or break level for the U.S. 10 year yield as well (as it is tracking German yields at this stage). While lower yields from here in these two key markets might sound great to some, it comes with a lot of problems, not the least of which is a negative message about the outlook for the global economy and thus damage to global confidence. Keep an eye on German yields, the most important market to watch in the coming days.
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In the middle of June we have perhaps the two biggest events of the year. On June 15 the Fed will decide on rates. And hours later, that Wednesday night, the Bank of Japan will follow with its decision on policy.
This is really the perfect scenario for the Fed. The biggest impediment in its hiking cycle/”rate normalization process” is instability in global financial markets. Market reactions can lead to damage to consumer sentiment, capital flight and tightening in credit—all the things that can spawn the threat of a global economic shock, which can derail global recovery. Clearly, they are very sensitive to that. On that note, the Brexit risk, while a hot topic in the news, is priced by experts as a low probability.
So, the Fed has been setting expectations that a second hike in its tightening cycle could be coming this month. But the market isn’t listening. The market is pricing in just a 23% chance of a hike in June. But as we’ve said, markets can get it wrong, sometimes very wrong. We think they have it wrong this time. We think there is a much better chance. Why? Because they know the BOJ is right behind them. If they do hike, any knee jerk hit to financial markets can be quelled by more easing from the BOJ.
Remember, as we’ve discussed quite a bit in our daily notes, central banks remain in control. The recovery was paid for by a highly concerted effort by the world’s top economic powers and central banks. And despite the perceived hostility over currency manipulation, the powers of the world understand that the U.S. is leading the way out of recovery, and that Europe and Japan are critical pieces in the global recovery. The ECB and BOJ have been passed the QE torch from the Fed to both fuel recovery and promote global economic stability. And playing a major role in that effort is a weaker euro and a weaker yen.
The Bank of Japan is operating with one target in mind, create inflation. Now three years into their massive program, they haven’t posted a positive monthly inflation number since December. Inflation is still dead, just as it has been for the past two decades. So, not only do they have the appetite and global support to do more, but the data more than justifies more action.
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Intervention has been the common theme we’ve discussed for the better part of the past two months. And this week, that theme is heating up.
We’ve explained why oil at $30 has posed a threat to the global financial system and global economy. And we explained the parallels of the systemically threatening (current) oil price bust and the 2007-2008 housing bust. But we also noted the key differences, and why and how this “cheap oil” problem could be easily solved, unlike the housing bust.
Gold has been a core trade for a lot of people throughout the crisis period. When Lehman failed in 2008, it shook the world, global credit froze, banks were on the verge of collapse, the global economy was on the brink of implosion – people ran into gold. Gold was a fear-of-the-unknown-outcome trade.
Then the global central banks responded with massive backstops, guarantees, and unprecedented QE programs. The world stabilized, but people ran faster into gold. Gold became a hyperinflation-fear trade.
In the chart above, you can see gold went on a tear from sub-$700 bucks to over $1,900 following the onset of global QE (led by the Fed).
Gold ran up as high as 180%. That was pricing in 41% annualized inflation at one point (as a dollar for dollar hedge). Of course, inflation didn’t comply. Still eight years after the Fed’s first round of QE (and massive global responses), we have just 13% cumulative inflation over the period.
So the gold bugs overshot in a big way.
Why? The next chart tells the story…
This chart above is the velocity of money. This is the rate at which money circulates through the economy. And you can see to the far right of the chart, it hasn’t been fast. In fact, it’s at historic lows. Banks used cheap/free money from the Fed to recapitalize, not to lend. Borrows had no appetite to borrow, because they were scarred by unemployment and overindebtedness. Bottom line: we get inflation when people are confident about their financial future, jobs, earning potential … and competing for things, buying today, thinking prices might be higher, or the widget might be gone tomorrow. It’s been the opposite for the past eight years.
After three rounds of Fed QE, and now mass scale QE from the BOJ and the ECB, the world is still battling DE-flationary pressures. If gold surged from sub-$700 to $1,900 on Fed/QE-driven hyperinflation fears, and QE has produced little to no inflation, it’s fair to think we can return to pre-QE levels. That’s sub-$700.
We head into the weekend with stocks down 3% for the month. This follows a bad January. In fact, the stock market is working on a fifth consecutive negative month. The likelihood, however, of it finishing down for February is very low. It’s only happened 18 times since 1928. So the S&P 500 has five consecutive losing months just 1.7% of the time, historically.
The Fed met today—and they made no change to policy. As we all know, their words will be parsed endlessly. But the fact is, the Fed, at this point, is a side show. It’s two other central banks (BOJ and ECB), and likely policy makers in China that will dictate what stocks do, what commodities do and what the global economy does for the next year (or few).
With that, the real event is tomorrow night. The Bank of Japan will decide on their next move. And the BOJ holds many, if not all of the cards for the U.S. stock market and the global economy. Today we’re going to talk about why that’s the case.
As we said yesterday, the consensus view is that the BOJ will do nothing this week. That sets up for a surprise, which Japanese policymakers like and want. It gives their policy actions more potency.
We talked yesterday about the role central banks have played in the long and slow global recovery. To put it simply, central banks have manufactured the global economic recovery. Without the intervention, there would have been a global economic collapse and blood in the streets, still. It was all led by the Fed. They slashed interest rates to zero. They rolled out the unprecedented bond buying program that pinned down mortgage rates (putting a bottom in the housing market), and helped to recapitalize the big banks that were drowning in defaulted debt, withering deposits and an evaporation of loan demand. They opened up currency swap lines (access to U.S. dollars) with global central banks so that those central banks could fend off collapse in their respective banking sectors.
Most importantly, with all of the intervention, and after spending and committing trillions of dollars in guarantees, backstops and bailouts, the Fed clearly communicated to the public, by their actions, that they would not let another shock event destabilize the world economy. Europe was next to step up, to do the same.
When the weak members of the European Monetary Union were spiraling toward default, which would have destroyed the euro and Europe all together, the leading euro zone nations stepped in with a bailout package.
Still, a year later, bigger trouble was brewing, as big countries like Italy and Spain were on the precipice of default. That’s when the European Central Bank (ECB) went “all–in”, effectively guaranteeing the debt of Italy and Spain by saying they would do “whatever it takes” to save the euro (and the euro zone).
Those were the magic words: “whatever it takes.”
That statement meant that the central bank would buy the debt of those countries, if need be, to keep them solvent, for as much and as long as needed…”whatever it takes.” That was the line in the sand. If you bought European stocks that day, you’ve doubled your money will little–to–no pain.
Similarly, Japan read from Draghi’s script a few months ago (late September of 2015) when global stocks were falling sharply and threatening to destabilize the world again. Japan’s Prime Minister Abe was in New York, and in a prepared speech, said they would do “whatever it takes” to return Japan to robust sustainable growth. Once again, the magic words put a bottom in global stocks and led to a sharp rebound.
“Whatever it takes” means, if need be, they print more money, they will support government debt markets, they will outright buy stocks, they will devalue currencies, they will do whatever it takes to promote growth and to prevent a shock that would derail the global economy. Why? Because they know the alternative scenario/the negative scenario is catastrophic.
Not surprisingly, in the past six days, with global stocks in turmoil, Draghi stepped in again. This time, he conjured up some new magic words. He said there are no limits to what the ECB can buy (as part of their QE program). Guess who followed his lead? The head of the BOJ sat in front of a camera the next day and said the exact same thing. This tells me stocks are fair game. We already know that’s the case for the BOJ. They are already outright buying stocks. But it also tells me commodities are fair game. And high yield corporate debt. Anything that is threatening to destabilize global markets and threatening to knock the global economic recovery off path—it’s fair game for the ECB and BOJ to put a floor under (i.e. by buying up assets with freshly printed currency).
What does it all mean? It means the ECB and the BOJ are now at the wheel. They relieved pressure from the Fed, allowing the Fed to begin the path of removing the emergency policies (albeit very slowly) of the past nine years. The Fed only makes this move because they believe the U.S. economy is robust enough to handle it. And, more importantly, they only start this path because they know that two other major central banks in the world will continue to provide fuel for the global economy and defend against shocks through their aggressive policies.
Now, within this monetary policy dominated world, where everyone is all–in, the policy actions have simply kept the global economy alive and breathing, they have done nothing to address the major structural problems the world is enduring: Massive debt and slow–to–no growth.
What’s the solution? There hasn’t been one. Until Japan unveiled their massive stimulus program in 2013. The potential solution: A massive devaluation of the Japanese yen.
Japan, unlike many other major central banks (including the Fed), has all of the right ingredients to achieve its inflation goal via the printing press—it has the biggest debt load in the world (which can be inflated away by yen printing), it has persistent deflation (which can be reversed by printing), and it has decades of economic stagnation (which can be reversed with hyper easy money and improvements in the global economy).
In short, they can do all of the things that other powerful central banks/economies can’t do—and it can result in a huge benefit not just in Japan but for fueling a recovery in the global economy (as capital pours out of Japan). In a world with few antidotes to the structural economic problems, this is a potential solution for everyone. So perhaps the most important ingredient for a successful campaign in Japan°they have the full support/hope/wishes of the major global economic powers (US, Europe, UK).
The Bank of Japan is targeting to run their aggressive QE program at full tilt until they can produce a target of 2% inflation in their economy. Their latest inflation data is closer to zero than 1% (still very far from 2%). So they still have a lot of work to do. They completed two years of their big, bold plan—and two years was the timeline they projected to achieve their goal. Clearly, they haven’t met the inflation goal. And they have since, as we’ve said, committed to do whatever it takes to do it, and for as long as it takes. With that, we expect more expansion to their QE program (possibly this week). And, importantly, a huge part of their success is (and will be) dependent upon higher Japanese stocks, and a weaker yen. They have explicitly said so. It’s part of their game plan.
Japan’s Prime Minister Abe was elected on his aggressive plan to end deflation. That was, and is, his priority. He hand-selected the Bank of Japan governor to carry out his plan.
Here’s the quick and dirty summary: With free–falling oil and depressed commodity prices threatening widespread defaults across the energy sector, which would soon be followed by sovereign debt defaults from oil producing nations (like Russia), don’t be surprised if we see the BOJ (and maybe the ECB) step in and gobble up dirt cheap commodities as a policy initiative. It would put a floor under stocks, commodities, and promote stability and growth.
We’ve talked about the bullish technical break occurring in stocks. That’s continuing again today.
