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Thou shalt not short bunds

13 March 2015
Richard Kemmish


At a dinner recently I sat next to a hedge fund manager who had put on a heavily leveraged long position on German government bunds at minus 5 basis points. He hadn’t put the trade on at a positive yield and felt smug about the rally, he wasn’t buying bunds despite the yield for the preservation of his capital, he put the trade on for capital appreciation purposes. Eloquently – we weren’t even on the second bottle – he tried to persuade me that on the basis of the Taylor rule, which links inflation to policy rates of central banks, the five year bund would go to -3%. 

For a very long time being short bunds was the ‘feet first’ trade – so named because that was how you would be carried off the trading floor. What is it about zero? Why is it so shocking to hear someone say that the trend will continue rather than suddenly end just because we are at the magical number, zero? I read a copy of the FT recently that referred to the concept of investors paying to lend in seven different articles (yes, I counted them) as if it would be the abrogation of a  law of nature.

Several people (negative-yield-deniers?) have said that recent heavily negative yields must be temporary and that ‘absolute zero’ for the bund market is minus 20bps. The shape of the bund curve at longer maturities suggests that this view prevails (interestingly the Swiss government bond curve fundamentally disagrees). Why do the deniers think this?

Firstly, the ECB deposit rate is currently minus 20. Yes it could go lower yet again. But this is the point at which the depo rate stopped and bond buying started to be the main instrument of ECB policy. At minus 20, they stopped using aspirin and reached for the defilibrator. It is interesting that the Fed and Bank of England – who were ahead of the ECB – both felt an urge to stop at broadly similar levels (zero and plus 50bps respectively).

Secondly, cash arbitrage. Negative yields for retail deposits are truly frightening to the extent that retail starts to withdraw cash and puts it under the mattress (hopefully only a proverbial mattress, not a literal one. If I were a bank regulator I think I’d insist that any bank planning to offer negative yields on retail deposits should offer free safety deposit boxes for customers with large cash holdings).  

Assuming though that corporate deposits are the real driver of this (corporate cash holdings being as insanely high as they are), how can a corporate avoid a negative deposit yield? Potentially the practical problems of holding bank notes could be overcome (or at least mutualised) by a banknote backed ETF (advertising slogan: ‘zero return....guaranteed. Leverage available, but pointless’).

Is there a way to avoid the cash arbitrage? A joke candidate in the British election has proposed that the pound coin should be worth 105 pence to make everyone richer. It isn’t impossible for the ECB to do the exact opposite.

-3% on bunds? Maybe.

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