Gadfly

World’s ‘Most Distorted’ Market Offers Widowmaking Trade

Betting against German bonds didn't work out for Hugh Hendry. Or Bill Gross. Sure you wanna go there?
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Photographer: Artur Widak

Quantitative easing has obliterated price discovery in financial markets. Central bank efforts to pump liquidity into the system have driven prices across several asset classes to levels that are (arguably) irrationally exuberant, with negatively yielding sovereign debt being the most conspicuous example.

Markets, though, can remain irrational longer than you can remain solvent -- particularly when the trading arena in question is the German government bond market.

The German pain trade put paid to Hugh Hendry, who last week announced the closure of his Eclectica hedge fund after 15 years. Hendry lost 3.8 percent in August, almost all stemming from a gone-wrong bet on a rising two-year German yield. "The most distorted asset class in the world is the two-year German bond," Hendry told Bloomberg Television on Friday.

Lending money to the German government for two years currently costs investors about 0.7 percent per annum, because yields are negative. That's more than the 0.56 percent it cost them in June.

And while the consensus forecast for yields in the coming quarters suggests you'd make money by betting on a price decline in the current two-year benchmark note repayable in September 2019, your profits would be small beer compared to the risk of the trade going awry.

As with any high-conviction trade, you could add leverage to swell those profits. But leverage works both ways, boosting your potential losses as well as your upside. 

And Hendry is far from alone in making the wrong call on bund yields. Germany's two-year borrowing cost has remained stubbornly below where analysts have predicted it would be by the end of the year -- which in turn calls into question how reliable the consensus view is going forward.

It's been more than two years since legendary bond investor Bill Gross described betting against 10-year German government bonds as "the short of a lifetime." Here's how that trade would have performed, based on the price of the relevant futures contract.

Gross failed to profit from even that initial downturn in price, as my Bloomberg News colleague Miles Weiss reported in May 2015. The move came faster than Gross had anticipated; the corresponding rise in volatility contributed to a 2.6 percent loss for Janus Capital Group Inc.'s Global Unconstrained fund in the two weeks or so after Gross recommended the trade.

Next month, the European Central Bank is expected to reveal at least some detail about how it plans to recalibrate its bond-buying program to reflect the euro zone's improved economic outlook. The Federal Reserve is on track to start reducing its balance sheet, continuing to tighten monetary policy. 

But it's far from clear whether central banks taking their collective foot off the monetary accelerator will lead to higher yields. Betting against German government bonds will remain a higher-than-usual-risk game for the foreseeable future.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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