Beware the Bund.
By Geoffrey Smith
May 12, 2015

The bond market, as Bill Clinton’s adviser James Carville famously noted, “can intimidate everybody.”

It’s been scaring investors in bonds for the last couple of weeks, and now it’s starting to scare the stock markets too.

The trouble is, although plenty of people suspect they know why, there isn’t a single identifiable trigger for what has been happening.

Some factors have certainly played a part: oil prices have rebounded (they’re now up 50% from their bottom earlier this year), so the risk of deflation has fallen sharply. Headline inflation in the Eurozone (where this current bond rout started) bottomed at -0.6% in January and is now back at -0.1%. The rebound in the Eurozone’s economy in has already led some to speculate that the European Central Bank will start ‘tapering’ its bond purchases well before its target date of September next year, removing the crucial prop to market sentiment that has driven a wild rally since the end of last year.

The E.U. last week revised up its growth forecasts for this year for virtually all its member states except Greece: that alone suggests stocks ought to a better investment than German or French government bonds that guarantee you a loss if you hold them to maturity.

Back in the U.S., one can see a similar influence from market expectations, as investors look through a spate of weak data that combined to generate the weakest quarterly GDP rise in a year.

But other factors have failed to play the role you might expect them too. Specifically, the impact from the Greek crisis is not affecting markets the way it used to. Athens is still clearly heading towards a default. It failed to make any meaningful progress at Monday’s ‘Eurogroup’ meeting of finance ministers and although it just about made a €775 million to the International Monetary Fund this week, it has all but exhausted its cash reserves.

For most of the last five years, news like that has tended to drive money into assets perceived as safe (such as German bonds) out of assets perceived as risky (such as Italian ones). But as this graph demonstrates, even that hasn’t held recently.

Beware the Bund.

Although the markets started to see Greek risks growing as soon as former Prime Minister Antonis Samaras called early elections last October, they ignored any wider implications for the Eurozone until spring. In the last couple of weeks, German, Italian and Spanish debt have all suffered more or less equally.

One of the reasons for that may be in the changed structure of global bond markets in the post-crisis age. As the IMF argued last month in its Global Financial Stability Report, the fixed-income fund universe is now more susceptible than ever to herd behavior, given the prevalence of passive, index-tracking funds. Even actively managed funds tend to behave similarly, with performance standards dictated by a limited number of benchmark indices. Such fears haven’t exactly been dissipated by the way the market sell-off gathered in strength after bond market guru Bill Gross called German bonds “the short of a lifetime.”

“Many funds are in similar trades with similar risk parameters, so when those trades go underwater, many liquidate their positions at the same time,” RBS analyst Alberto Gallo said in a note to clients Monday. Moreover, Gallo noted, “a typical asset manager’s fee of (0.5%) of assets under managements is an increasingly large percentage of the yields available. Up until last week, investing in German Bunds of any maturity wouldn’t have earned enough even to make back the fee. This may encourage funds to exit those positions more quickly if they go underwater, rather than sticking with the trade for the long-term.”

Despite the fact that the pattern repeats itself time after time in financial markets (the clearest example being 1987), stocks are often late to realize the implications of bond market routs. Of course there are reasons to be optimistic too, but this graph from Bank of America Merrill Lynch begs the question whether the age-old pattern won’t be repeated once again before too long.

Money is actually flowing out of U.S. stocks. How long can valuations defy gravity?


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