In the US I think the increase in long bond yields is long overdue, and I believe that the 10-year yields will slowly rise to the three percent level as the US economy shows further sign of momentum.
The central bankers’ mantra? Interest rates have to be low in order to make certain the real economy gets the loans it needs. They’ve been saying this in the US for years, as they have in Europe and Japan. However, nuances have crept into the mantra ever so covertly. As a result, bond investors need to listen very carefully. But let’s start at the beginning.
Interest rates are obviously something like the financial markets’ reins. Pull hard on them and you brake developments. Provide slack and ease off whenever the economy has not got beyond walking pace. If such a low-interest phase persists for too long, interest can become an encumbrance for investors. As the interest on bonds is also aligned to the base rate. Nevertheless, investors are, for example, still buying ten-year Bunds although these now actually cost you money, as you pay more for the instrument than you get back in interest and redemptions when it matures. Meaning you the buyer accept a surefire loss in exchange for the security afforded by a sound debtor.
Investors must be even more patient if interest rates get raised. Because then the prices for their bonds decrease as the lion’s share of investors chuck their low-interest bonds on the market and pile instead into securities offering higher yields.
Is an interest rate rise in the Euro zone merely a future scenario? No. Because the European Central Bank (ECB) has been coyly toying with the idea of late. Most recently, it was one of the members of the ECB Board who mentioned the prospect of an end to the policy of low interest rates. After all, the global economy has stabilized and inflation is picking up, on both sides of the Atlantic. And central bankers tend to read that as a call to action. The interest-rate hike will come, the only question is: When?
Interest rates are pretty well at the lowest levels throughout history. In fact, compiled from various different countries, going back more or less five thousand years, yields have never been as low as they have been in recent months.
The spread between the Bund and the US Ten-T note has widened to about 200 basis points, which is about two percent, and not seen since the early 1990s.
One of the most significant changes in the world economy in the past couple of decades has been the decline in real interest rates and the commensurate rise in indebtedness.
Waiting for the wake-up call
So what to do? Many are simply sitting on their hands, among other things in the hope that until things happen they can exploit the supposed interest rates. In the long term, with a view to the pending price losses, that is a risk. And the longer the maturity period, the more painful the possible losses. That nasty wake-up call could come. Indicated first by the already discounted base rate hike in the US, and second by the Fed’s express intention of reducing its balance sheet. Both taken together could spell the abrupt end of the era of enduring calm in the bond market. The question again is when, and how fierce will this end be?
A zeitgeist investor would therefore be prepared. First, because of the consequences if he is already exposed to bonds. Second, because of the impact on equities, which tend to suffer when the interest rates rise. So what is needed is an instrument that flexibly benefits from changes in the intrest rate. How about selling futures (short positions) on long Eurobonds? The latter are one of the most liquid investments out there. Futures are forward contracts granting the buyer the right to delivery of the bond at a fixed price irrespective of price movements. If a bond loses value, the short position afforded by the Bund Future gains accordingly. This also applies the other way round, if the bond price rises and interest rates fall. Then the hedge position against rising interest rates loses in value. The strategy even offers investors opportunities to make money in a scenario of rising interest rates and thus falling bond prices.
Often said and oft forgotten: Every risk also spells an opportunity. As long as you make the effort to ponder alternatives in due time.
Rising interest rates could indeed be negative for stock markets, especially if rates go up a lot faster than people expect. But, as so often in financial markets, a risk creates an opportunity, and that is the case here: those rising rates can actually be turned into a positive investment opportunity, hedging against them.
Published on 13.04.2017
|Euro-Bund-Future shorting||ComStage Commerzbank Bund-Future Short TR UCITS ETF||LU0530119774||0.20%||100%|