This week a new development was observed in the bond market. For the first time after a while the yields on 10-Year German Bunds rose above zero again. As of Friday market session close the yield on German benchmark paper stood at +0,069%, while 10-Year US bonds and 10-Year JGB’s ended the week at 1,805% and -0,059% respectively.

Yields bounced already a month ago quite substantially. However, the move did not last long and the trend reversed again to the downside for yields.

Current market move is supposed to be feed by comments of FOMC members. In their statements they are indicating they may be raising rates relatively soon. Actually the U.S. central bank is expected to deliver the next hike already this year as written in CNBC comments about what NY Federal Reserve President William Dudley said.

Traders report the market shows 65% chance of next rate hike by December 2016.



On the other hand, Wall Street Journal in an article points to the speculation that the selling in the bond market was due to investors’ sentiment and outlook in Germany, which brightened. On top of it, if major countries decide to exploit fiscal stimulus after monetary stimulus’ potential zenith, then there will be even more selling of bonds to finance such spending.

Last but not least, the change in technical picture could be a major reason for the acceleration in rising yields. The view on the mid-term horizon is that the yields have stabilized or are potentially going substantially higher. Technically the market has printed two major lows during recent months and has always bounced back decisively. If market communicated it does not want to trade bellow -0,1% on 10-Year German Bund yield, then technically the risk reward trade is aggressively pointed toward rising yields.



Nevertheless, this is all a very traditional and conventional view of bond market mechanism. To us most important data point is price of risk. From this perspective bond market is completely aligned with the fact that risk free rates in the composite FX have gone up substantially after last Friday when GBP momentarily panicked. The rise in bond market yields is a natural consequence.

The rise in FX volatility for example was not accompanied with substantially lower prices in the pound. All volatility that was quoted directly after the event was more dominant than the price offset that happened. During half an hour British Pound Sterling offered 3% floating risk free turnover. At such great turnover for investors price risk is inexpensive.

If we consider the bond market to be a close cousin to the FX market, which it is, then the increasing returns in the FX can be leveraged by selling bonds, because bond yields are still lower than composite FX risk free rates of the same maturity. An institution with access to bond source to be sold or sold short can leverage the highly liquid returns on FX and can do so very cost efficiently. Potentially long lasting duration of such a trade can provide benefits and an additional incentive to enter such trades around current market prices.

All in all, if GBP for example will not print a lot of new lows, then FX volatility will provide a force of support for long term bond yields increase. Inversely, if FX market will become dull and not move much, then because of lack of turnover bonds could reverse and head higher once more.

Gregor Kozelj

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