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Euro-Area Bonds Caught in QE Paradox


The European Central Bank’s bond-buying program has landed investors in a quandary that’s whipping up volatility in the region’s fixed-income markets.

Signs the plan is helping turn around the euro area’s economy triggered a 1.4 percent loss on the region’s government bonds in April, the first in 16 months. That selloff has spiraled into a rout in the first days of May, with eighth straight days of declines for German 10-year bonds.

“If you really believe the ECB is going to be successful in re-anchoring inflation expectations, it made no sense for the bund to trade at the level of yields it was just a few weeks ago,” said Jean Medecin, who helps manage the equivalent of $58 billion as a member of Carmignac Gestion SA’s investment committee.

Medecin has joined the ranks of investors scenting an opportunity to bet against bunds even as the ECB buys about 11 billion euros ($12.5 billion) of German government debt each month. DoubleLine Capital LP’s Jeffrey Gundlach last week said he’s considering making an amplified bet against short-dated German notes, and Janus Capital’s Bill Gross said bunds were the “short of a lifetime.”

The bears are looking to signs of inflation in the euro area, which erodes the purchasing power of the fixed payments on bonds. Data released last week showed euro-area consumer prices halted a four-month drop in April and lending by euro-area banks to companies and households rose for the first time in three years in March.

Bull Run

Even so, not all investors are heading for the exit. Euro-area government debt returned 4.3 percent in the first quarter as investors piled into the securities, betting the ECB’s pledge to buy bonds would create a scarcity of fixed-income assets. The central bank only began its purchases of 60 billion euros of debt a month in March, planning to continue through September next year.

Central bank demand is set to outweigh new supply in Germany this year, a fact that may push bund prices higher.

“It’s unlikely that we are going to have a change in policy any time soon in Europe,” said John Stopford, London-based head of fixed income at Investec Asset Management, which oversees $115 billion. “We need to see a sustained pick-up in growth and inflation to expect a change. That’s not the case now. Yields will fall further.”

Stopford says he’s been buying bunds as prices dip.

Two-Way Risk

The declines in 10-year bunds sent yields to 0.67 percent at 9:48 a.m. London time, wiping out all this year’s rally. They’re up from a record low of 0.049 percent on April 17. The five-year average is 1.78 percent.

“It brings the two-way risk back into the bond market,” said Sandra Holdsworth, a fixed-income investment manager at Kames Capital, who says she has been buying bunds and reducing her exposure to peripheral securities. “The European Central Bank get to buy their bonds at cheaper prices now. We’ll see some strength again.”

That risk is reflected in market gauges of future price swings on euro-area bonds. Implied volatility on 10-year German bund futures has surged in the past week to the highest since August 2012, data compiled by Bloomberg show.

Carmignac’s Medecin says his mind is set. “You have to have conviction and to have the courage to stick to your conviction,” he said in a Bloomberg Television interview in London on Tuesday. His short position on German bonds was “in the anticipation of the success of the ECB program,” he said. “It was really a reflation trade.”

(Source: Bloomberg)