Why did German bunds selloff so violently?

When the ECB announced QE, traders attempted to front run the program. The program would buy bonds according to the capital subscription of the national central banks to the ECB. On that count, bunds would see an 18% allocation of the budget, France 14%, Italy 12% and Spain 9%. Traders reasoned that bunds would see the biggest allocation not only in absolute terms but relative to the stock of bonds available. The problem with this thesis was the investors who had over 2 years of profits ready to crystallize.

A less volatile trade expression for QE was to realize that with risk mutualisation, 20% explicitly and 100% implicitly through TARGET2, it made sense to sell protection on Italy, Spain, Portugal and to buy protection on Germany and France.

When the Maastricht treaty was signed, peripheral spreads over bunds were much wider than they are today, some 4%-5%. They spent the best part of a decade converging, in the case of Italy, to a negative spread to bunds… In 2012, spreads widened to pre Maastricht levels as country risk reasserted itself in the European sovereign bond market. Since the ECB’s “all it takes” policy, spreads have converged again. We are currently still well wide of zero and convergence remains a logical trade.

The Chinese economy generated about 10.4 trillion USD of nominal output in 2014, representing incremental nominal output of 680 billion USD, equivalent to 7.0% growth. If the Chinese economy continues to generate this same incremental nominal output of 679 billion USD this year and next, 2015 growth will be 6.54% and 2016 growth will be 6.14%. This naïve calculation provides one potential lower bound estimate for a safe landing for the Chinese economy, that is growth rates that would not trigger significant unemployment, deflation and social unrest. On this trajectory, China will have slowed to mature market rates of growth by 2030.

Incidentally, the Economist forecasts growth of 6.90% in 2015 and 6.80% in 2016.

A business cannot borrow itself into solvency. On the other hand there will be a cost of debt beyond which no business model can survive. What Greece needs to do is examine its business model to get a handle on its revenues and expenses (including unfunded liabilities), examine its balance sheet (including state owned assets) and find a viable business model (from a cash flow and profit perspective) and balance sheet.

A rational creditor would work with Greece to maximize the value of the loans they have already extended to Greece. This could very realistically involve extending more credit to Greece, at easier terms. A rational creditor would only agree to this if there was a formal business plan.

In order that any such business plan was sufficiently reassuring to Greece’s creditors, cash flows from tax and other revenue might have to be directed to escrow accounts where a waterfall of priority of cash flows directed cash so as to satisfy basic needs of the Greek government and people, then creditors, then less high priority Greek interests.

The Chinese economy is clearly slowing down and the PBOC is reacting by providing stimulus to maintain a sustainable rate of growth. It needs to do this in a balanced way without undoing some of the credit market reforms that have been enacted in the last year. On Sunday, the PBOC announced a 0.25% cut to its benchmark 1 year lending rate (to 5.1%) and its benchmark 1year deposit rate (to 2.25%) while raising the deposit rate ceiling from 130% to 150%.

The PBOC is seeking to reduce borrowing costs and boost output while keeping asset bubbles from inflating, particularly in its real estate market, stock market and shadow banking system. The PBOC has a host of monetary policy tools at its disposal including the Standing Lend Facility, Medium-term Lending Facility and Pledged Supplementary Lending, analogous to the ECB’s MRO and LTRO open market operations. The PBOC said recently that there was no need for QE at this point and would rely on its open market operations.

The economy is slowing down but conditions are in place for stabilization and recovery.

That said, the PBOC will likely continue to operate expansionary policy while the economy rebalances towards more consumption and less exports and investment.

Conditions are supportive of equity and risk assets, however, the current volatility may persist a bit longer as the PBOC seeks to avoid a hyperbolic equity market bubble.

Credit market reforms have been enacted that will see greater market discipline. Expect increased defaults among smaller and non-systemic issuers, even among SOEs.

A short EUR position has been a consensus trade for most of 2014. Recent EUR volatility and the contentious negotiations about Greece’s finances challenge the consensus.

If Greece manages to stay in the Eurozone it will be by postponing its problems and continually deferring default and exit. The Euro would be weak under this scenario. Volatility would remain elevated with bouts of strength at each narrow escape. This is not rational but markets are often not rational. Greece’s membership of the Eurozone should cheapen the EUR not strengthen it.

If Greece is removed from the Euro it would be positive for the currency. While short term reactionary price action is difficult to predict, one would expect a Grexit to promote EUR strength with the EUR heading perhaps to 1.30 to the USD. This could hurt European exports and growth.

Herein lies a trading strategy.