EXIT: 2021 central banks’ megatrend

The Euro Bund futures contracts are telling us the same. Our Technical Analysis guru, Kim Cramer, says: “Over the past 4-6 weeks Euro Bund has been trading in a more and more narrow bearish range forming what looks like a Falling Wedge.  However, the RSI values have been rising, which means there is growing divergence. In other words, the downtrend is weakening, nearing exhaustion levels and could reverse. If Bunds breaks out to the upside, there is some resistance at 171.44 but room up till 171.91. A close below 169.47 will most likely result in Bunds to drop to around 168-167.50”.  

Today's BOE meeting is a massive blow to the ECB's policies which have been trying for weeks to keep European yields in check. It is time to realize that there is no escaping the tapering anywhere globally, not even under the ultra-dovish monetary policies rules of the ECB.

2. Investors have chosen between credit or duration risk, and they are now waiting

Within this context, investors need to pick one of the two: credit or duration?

Both risks have a common goal: securing a yield high enough to hedge against a rise in inflation.

Yet, the difference between them is massive. It is like choosing to die a sudden death or slow death because interest rate risk punishes duration harshly, but credit risk may result in defaults.

Let’s take the Austria 2120 bonds, for example. These bonds were issued in June 2020 with a coupon of 0.85%. The low coupon provides a little buffer to protect against interest rates. Since Bund yields have started to point higher in December, the bonds have fallen substantially around 50 points in nominal terms, 35% of their price.

The issue is that Bund yields have just started to rise. Rising yields in the US and the German election in the fall are pointing to one only certainty: Bund yields are meant to turn positive. It will provoke pain to ultra-long bonds that have been issued under extraordinary circumstances while central banks accommodative measures where compressing risk premium worldwide. It means that the price of these bonds can easily fall another 20 to 30 full points, and the question that one should ask is: how long are you willing to hold on to this instrument?

Maybe pension funds and insurances might endure low valuations for quite sometimes but what about smaller investors? While big players have soaked in duration, the small crowd is in higher-yielding credits. Neither risks are optimal, but I know where my preference is. In a rising interest rates environment, I would shy from duration any day.