Fasanara Capital’s Take On Bunds Market Riot

Fasanara Capital’s investment outlook for June 1, 2015.

1. Bunds Market Riot: Our Take

Seismic Markets. Liquidity-induced markets are prone to asset bubbles and recurring bouts of volatility. Thin liquidity, low inventories, abundant leverage, crowded positioning on consensus trades, on stretched valuations when not outright asset bubbles, make VaR shocks inevitable.

2. Our Medium-Term View: Deflationary Boom Markets

Our bearish view for global economies, and especially so for Europe and Japan, entails that the strenuous battle against die-hard deflation will force the hand of Central Bankers into monetary printing, driving up further bonds and equities.

We expect: Bund weakness to maybe last another couple months and then fade away, taking yields into new lows. Spreads between European government bonds to tighten back to pre-ECB’s QE levels, and then eventually reach new lows. Spreads cross-markets to compress, Interest Rate Curves to flatten. European Equities to move to new highs, melting up further

3. Our Long-Term View: Deflationary Bust ?

If we are right about the global economy, there will be no normalization of growth rates, just sluggish GDP growth, deflationary trends may prevail, over-indebtedness may go uncured, un-employment may remain high in Europe. Against such backdrop, Central Banks will continue pumping liquidity and fueling the bubble, until their arsenal runs thin, at which point political regime changes may provoke an unplug. In Europe, a dissolution of the currency peg (EUR break-out) would then be a genuine option.

4. Deflationary Trends: Secular Stagnation or Global Savings Glut

Structural deflation is the backbone of the macro outlook we endorsed for the last few years. Here below we will try to characterize our conceptual framework on Secular Stagnation and Structural Deflation a bit better.

5. Greece: Three Scenarios

We think that the three events are separate and to some extent independent: (i) Technical default, alone, (ii) Technical default leading to ‘Grexit’, alone, (iii) Technical default leading to ‘Grexit’, leading to panic/contagion across global markets. The first scenario of a technical default is potentially a favorable one, and preferable to a muddle-through situation: a technical default (where not only debt but also wages/pensions go unpaid in Euros) could potentially tip over the current government in Greece and can therefore lead to a best-case scenario.

6. Crystal Ball

Our Target Levels for S&P, Nikkei, Eurostoxx, Fed Fund Rates, US Treasuries, Bunds, BTPs, WTI, Gold, USD, JPY, EUR, CNH, inflation, spreads

Bunds Market Riot: Fasanara Capital’s Take

The most informative and impactful event of the last few months has undoubtedly been the VaR shock on German government bonds. The 10yr Bund moved from 0.05% yield to 0.77% in a rapid shift, catching most investors by surprise, including us, sending shockwaves across bond markets in Europe (on peripheral European yields and spreads, pushed to pre-ECB ‘s QE levels) and the US (where ultra-long Treasuries moved back above 3%, for a time).

The brutal move on Bunds, a 10-sigma event when measured against deceptively low levels of (daily realized) volatility, is confirmation of the dislocated markets we live within, and joins the list of numerous other recent schizophrenic episodes and sudden bouts of volatility, what we described in the past as ‘seismic markets’.

One more confirmation of fat-tailed distributions (as opposed to normally-distributed), exhibiting a tendency for outliers: low-probability high-impact events do occur (statistician David Hand would say ‘must occur’), deep excursions from the central value do happen, and when they do their magnitude is great. What we failed to see this time around is another connotation of today’s markets we must account for: a bias for CoVaR to spike at times, sky-high cross-asset correlation to kick-in, especially in downside scenarios for markets, pushing an idiosyncratic risk into a systemic one.

Fasanara Capital's Take On Bunds Market Riot

Unfortunately, having foreseen the disposition to dislocations of current markets did not make us anticipate this one specific move on Bunds. It caught us by surprise. All we could predict is the inability to maintain portfolio’s volatility low in today’s markets while pursuing high returns, given the very nature of those markets characterized by seismic activity.

In justification of the move in Bunds, we can (uselessly ex post) think of a few concurring factors:

– All too obviously, liquidity-induced markets are prone to asset bubbles, but also prone to recurring volatility shocks. Thin liquidity, low inventories, abundant leverage, on stretched valuations when not outright asset bubbles, around crowded positioning on consensus trades, have all contributed to this move on government bonds. Unexpected losses on the part of the portfolio that should be the least volatile (risk parity funds in primis), have triggered stops and unwinds, which fed on the sell-off. Margin calls on excessive leverage created then overcompensation to the downside, and overshooting. Admittedly, a textbook reaction to asset bubbles in overleveraged markets.

– Additionally, the move was fueled by some seeing ECB’s policies being successful in reigniting some form of inflation expectations, as reflected by economic releases surprising to the upside (although in minimal fashion), a stronger Euro, and the 5y5y forward inflation swaps moving ca. 30bps higher from the lows reached in January. Investors expecting that would call it ‘normalization of markets’, and reversion to the mean of a pre-Lehman economic environment. We do not see it as sustainable and durable, but it surely took place this time around and played a role.

– Also, outside of Europe, the move was helped by somehow higher Emerging markets’ equities and currencies (especially equities), somehow higher commodity markets (oil in primis, rebounding at some point 40% from the lows, but also copper and iron ore, in turn driven by some expectations of liquidity injections in China, where Shibor rates halves from 4% to 2%, at a time when a Chinese competitive devaluations seems to be in the bucket list of many traders).

Fasanara Capital classify the Bund movement as idiosyncratic, for it was not validated by other asset classes all around it, be it equities or FX. The nature of the dislocation is detectable in equity markets behaving like bond markets, while bond markets behaving like equity markets. Whilst Bunds were losing 20% of their value, in equity market-type volatility (or even private equity market-type volatility, nowadays), the DAX index was losing approx. 7% from its peak, a bond market-type volatility. In a way, in the last few months, a good allocation to equities would have helped hedge the downfall in the bond markets, paradoxically. Think also of the FTSEMib, the Italian stock market, close to the highs of the last several years, while Italian government bonds were sent off trading close to the lows, both in absolute terms and relative to Bunds/OATs, as low as seen only before the ECB launched QE operations. The paradox is evident when thinking of an economic environment where data releases came out on the weak side of expectations (in the US and Asia), hardly confirming any imminent robust global economic recovery (which might have justified a combination of stable equities and rising interest rates): if anything, the United Nations forecast for WGP global growth was revised downward to 2.8%, dangerously close to the 2.5% which was once considered to be equivalent to a recessionary/stall speed global economy.

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