In the past 4 weeks there has been a significant shakeout in the bond markets. From previously having been seen as almost a one way bet, the yield on the German Bund (10 year government bond) has soared. This is giving investors in other assets classes significant cause for concern. There has been a positive correlation between the Bund yield and the euro. So what are the charts saying and is it likely to continue?
The yield on the German Bund had originally started falling from around 1.9% in early 2014 and with the ECB moving towards easier monetary policy the yield moved ever lower throughout last year. This move had continued into 2015 with the ECB choosing to use its ultimate weapon of sovereign debt asset purchases. With the majority of European bond markets falling into negative territory, the Bund was well on track for zero. However with everyone in the market convinced that it was a one way bet, the market for the Bund became too long. With volatility apparently at record low levels, something had to give.
Maybe it was the uptick in Eurozone growth prospects, or maybe it was more technically driven, but the trade is now reversing, in a big way. This is having big issues for the euro and if it continues, potentially also for equity markets such as the DAXas well.
With the ECB engaging in QE, there was a “carry trade” which lasted for the first few months of the year. With the euro falling in value, traders were borrowing in euros and using them to buy higher yielding assets (such as Eurozone equities). The fact that Eurozone bond yields (such as the Bund) were yielding so low (or even negative) meant that other assets still looked cheap on a risk premium basis.This was all well and good as long as bond yields continued at their recor low levels.
However, since the middle of April, there has been a remarkable turnaround in this trade. With the shakeout in Bunds, yields have been spiking higher. Suddenly the assets such as equities no longer look so cheap on a risk premium basis. Traders have been subsequently looking to unwind their “carry trade” which involves selling out of the higher risk assets and buying back into the euro. This has driven the euro higher over the past few weeks. The euro has been subsequently trading in close correlation to the Bund yield, although clearly on the chart above, the volatility has exploded on the Bund yield as the rebound has taken off. This relationship of the carry trade also helps to explain why the euro and the DAX have been on a negative correlation.
From a record low of 0.05%, the yield on the Bund has spiked higher by around 750 basis points. Interestingly the move has already found resistance around the 38.2% Fibonacci retracement of the huge 1.971% to 0.049% decline. This resistance comes in around 0.78%. If this can be breached then it would suggest that the next Fibonacci retracement of 50% is a real possibility at 1.01% on the yield. The next big price resistance level also comes in around 0.9%.
Note how the Bollinger Bands show how volatility on the Bund yield has exploded near term. However, the Bollinger Bands also suggest that if there is a failure to breakout above the 0.796% spike high then this could be a near term corrective signal. This is because the Bund reversed at 0.796% on a trading day entirely outside the Bollinger Bands and if there is a failure at that resistance inside the bands, then this would be a corrective signal. So far the Bund yield has shown strength is continuing and is once more rising today. The next couple of days could therefore be crucial to the near term prospects.
The key to the outlook is therefore this resistance overhead. So if you see an “8” handle on the yield it would suggest that there is further upside to be had, probably towards at least 0.900%. Continued rise in the Bund yield would be positive for the euro and negative for the DAX.
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