For footloose international money, the safest place to hide in the European financial system may be two-year German debt. The government of Europe’s largest economy not meeting such obligations in euros is as close to inconceivable as things get.
The debt is also easy and cheap to trade, which means it can be a market signal of investor angst. The price of such safety set a record on Wednesday, with buyers accepting a loss of as much as 0.92 per cent a year.
Yields, which move in the opposite direction to prices, then rebounded following the latest turn in France’s season of electoral jostling. Francois Bayrou, a potential independent candidate for president, pulled out of the race and backed Emmanuel Macron, a centrist former economy minister.
Investor fears of a shock victory for the far right under Marine Le Pen, who has pledged to pull the country out of the euro, appeared to ebb a little.
Yet measuring fear in the market is an imprecise science, particularly when it comes to existential questions about the European financial system. Alan Ruskin, foreign exchange strategist for Deutsche Bank, says: “It’s quite hard to trade a low probability, high impact event”.
For instance, different markets suggest various degrees of concern and complacency. The European and French stock markets are riding high after a three-month rally, with little violence in their day to day movement.
Traders can position for spikes in such volatility, and the derivative markets they use suggest April is expected to be more chaotic for stocks, the month when the first round of voting takes place. Their counterparts in foreign exchange, however, seem more concerned about May, when a run-off vote will pit the top two candidates against each other.
Other inconsistencies also emerge. On Wednesday prices for option contracts suggested significant demand for insurance against a big drop in the value of the euro against the dollar in the months ahead, but not for protection were the euro to fall versus the Canadian equivalent.
When it comes to the sovereign bond market, there are also multiple reasons for the yield on the two-year German bond, known as the Schatz, to be so far below zero.
“The 2-year bond is the other side of lots of trades”, says Michael O’Sullivan, chief investment officer for international wealth management at Credit Suisse.
Professional investors in bond markets will often construct bets around the movement of two different securities. So if they are wary of a deterioration in the public finances of the so-called peripheral countries within the euro, such as Italy, Spain or Portugal, they may sell those bonds and buy the safe alternative: German debt.
Europe’s economy is also showing signs of improvement, and many in the market debate when the European Central Bank will react to signs of returning inflation by reducing the amount of securities it buys each month to suppress borrowing costs.
Nick Hayes, manager of the global strategic bonds at Axa Investment Managers, points to the impact of economic growth on long-dated debt, with prices sensitive to higher interest rates. “There’s a pro-economic argument which is arguably less good for government bonds,” he says. The conclusion is to favour short-dated debt instead.
Mr O’Sullivan highlights shifting policy on the other side of the Atlantic, where the Federal Reserve is expected to raise interest rates again this year, maybe as soon as next month.
For those who think US short-term bond yields must go higher, and so sell two-year Treasury Notes, the other side of the trade can be to buy the German equivalent. Indeed, at just over 2 percentage points, the difference between the respective two-year yields is the greatest its been since 2000.
Political risk then becomes just one more aspect of pressure on Schatz yields, at a time when other indicators of stress remain well below the extremes witnessed during Europe’s sovereign debt crisis. A narrowing of opinion polls that improves the chance of Ms Le Pen winning could yet put further pressure on markets.
Indeed, so great would be the impact of a euro member re-denominating debts into another currency, even a small change in the risk of such an event could have significant effects.
Mr Ruskin says “the most misleading aspect of Brexit, is precisely that it is setting up complacency on ‘Frexit’, among both the voting public and nationalistic political classes in France and abroad. Make no mistake, there is the world of difference between tearing up bilateral and multilateral trade agreements and unwinding a monetary union as far reaching in scope as the EMU project.”
It would be, he says, something with the potential to go beyond a “Lehman moment”, the failure of an investment bank which triggered the 2008 crisis.
