The following story from Jon Macaskill, originally published end-June, is more relevant than ever post-ECB meeting.
Some high-profile investors, including Pimco head Bill Gross and hedge fund manager John Paulson, are taking their Sell Germany campaign on the road. They argue that Bund yields are so low that a bubble has developed, with prices failing to reflect the credit risks associated with Germany’s likely assumption of greater debt if the eurozone integrates further, or the effect on its economy if the euro breaks up.
Simple short sales of Bunds have been a disastrous bet this year, so the focus for trading this anti-Germany view has shifted to the credit default swap market. Buying of default swap protection has proved a much better wager. Even as Bund yields plumbed new lows in June on a renewed flight-to-quality bid for safe paper, German default swaps pushed out sharply and at times inversely to the rally in the underlying debt.
By the end of June, 10-year Germany sovereign default swaps were trading at 130 basis points, having started the year at 100bp, while the yield on the benchmark 10-year Bund was at 1.5%, having traded at and around 2% in January. The rise in the sovereign CDS level now threatens to remove the positive basis that has prevailed between Bunds and default swaps and provided comfort in the form of a cost-effective hedging option for holders of German debt who might share the concerns of Gross and Paulson about the absolute levels of yields.
If German default swaps continue to push outwards, a second-order effect might be felt in terms of a reduction in the relative funding advantage enjoyed by Deutsche Bank from its implied sovereign guarantee. JPMorgan and Deutsche Bank have been big beneficiaries of tight default swap levels relative to their main competitors in terms of securing increased client business since the 2008 crisis.
JPMorgan’s case for winning new business was based on the twin pillars of its “Fortress” balance sheet and its much-vaunted reputation for superior risk management ability. The second pillar crumbled when the scale of the botched combination hedges and proprietary trades in JPMorgan’s chief investment office were revealed. The first pillar still counts for something and five-year JPMorgan default swaps at 140bp in late June remained well below the 270bp for US rival Bank of America or the 290bp for Goldman Sachs. But the spread between JPMorgan’s CDS and other banks has narrowed since the revelation of the losses by its chief investment office.
Deutsche Bank does not have a balance-sheet advantage relative to its main competitors, at least in terms of lower leverage, so the value of its implied sovereign guarantee is of consequence. The divergence between Bund yields and German CDS levels might accordingly become increasingly important for Deutsche Bank’s funding costs. Five-year Deutsche Bank default swap quotes pushed above 200bp in late June and could rise further if the fad among fund managers for viewing Germany as the New Big Short opportunity continues.
Gross exposure
As with any contrarian pitch, there is no guarantee that the trade will pay off – at least in a short enough timescale to deliver for fund managers. Its two main exponents have certainly done plenty of damage to their reputations for trading prescience with recent market calls. Bill Gross of Pimco at times seems to be meandering from one major sovereign debt market to the next with warnings of impending doom that fail to translate into viable dealing opportunities.
Gross spent much of last year warning that US treasury yields were unsustainably low before admitting that he called the market wrong and reversing his own exposure to place himself in an unfamiliar position at the bottom of the bond fund performance league tables.
A memorable description by Gross of the UK gilt market in February 2010 as a “must-avoid” sector that is “resting on a bed of nitroglycerine” provides a reminder that his prognostications can also fail to pay off on a medium-term basis, as gilt yields have been falling ever since the comment.
Gross is not afraid to double down in his self-appointed role as the Cassandra of the sovereign debt markets, however. His widely read monthly outlook notes are becoming increasingly baroque in their language, but he has also recently taken to Twitter in order to deliver pithier opinions. A post on June 19 implied that anyone holding German debt rather than loading up on Mexican exposure was missing a trick. “Let’s see: would I rather own German or Mexican 10-year bonds? 1.5% or 5.7%? Huge potential debt/GDP or half that of US? Duh,” Gross tweeted.
It is not clear if Gross was serious about a switch from Bunds to Mexican bonds, although a yield compression trade would have paid off in the days following his Twitter post. It is clear that pair trading or a hedged position is the most practical way to make a view on German credit deterioration pay off, if only because of the powerful effect of the flight-to-safety bid for Bunds whenever global markets take fright. That has led to intense speculation about how John Paulson and his hedge fund subordinates are putting together trades to express their short-Germany view. Paulson shot to fame as the biggest single beneficiary of the 2007 and 2008 credit crisis, on the back of his short bets on sub-prime mortgages, and he delivered multi-billion dollar returns again in 2010.
Last year was a different story, though, with the Paulson Advantage Plus fund falling more than 50% and other funds in the group also losing ground. Longstanding bets such as exposure to gold have suffered again this year, so the execution of the Germany short could be a key determinant of whether the Paulson group can recover from its 2011 slump.
The short-Germany view was first articulated by Paulson to his broad investor group on a conference call in April. Most fund managers share views in this way after they have put their positions on, in order to develop momentum for the trade and increase liquidity in less heavily trafficked sectors such as default swaps.
Paulson certainly seems to have helped to increase liquidity in German sovereign default swaps, which have been steadily increasing in volume in recent months and now rank close behind troubled European nations such as Spain and Italy in terms of notional amounts traded. But Paulson and other hedge fund groups face a looming issue in the coming ban on naked buying of European sovereign default swaps, which is due to take effect in November. And gains on German default swap purchases will have been offset by losses on any short sales of cash Bunds. For the Sell Germany trade to turn into the Next Big Short, investors will need the cash market to crack, which does not seem to be in immediate prospect.
