Hello traders! In this week’s Lessons From the Pros article, I’d like to bring up a topic that is rarely discussed here, which is bonds. I’m not talking about futures contracts on bonds, but what bonds are and what they are telling us about individual countries today.
Before we get to the actual bond discussion, we have to understand a bit about currency strength and weakness and how it affects a nation’s economy. Take a look at your chart of the EURUSD, going back over a couple of years. You can see that the EURUSD has been trending down for several months, indicating a stronger USD vs. a weaker EUR. So who benefits from a stronger local currency, and who is hurt? The beneficiaries of a stronger local currency are the people who do more purchasing of imported goods. As the USD increases in strength vs. the EUR, any goods that are imported from the Eurozone will be cheaper. In this very basic Economics 101 discussion, a stronger dollar means when I purchase a new European car, or suit, or wine, they should be cheaper today than a couple of years ago. The beneficiaries of a weaker EUR would be their exporting countries and companies. So, who is hurt by a stronger local currency, in this case the dollar? Just the opposite. Any exporting companies here will be hurt, as their products will be more expensive overseas. People or companies who rely on imports in the Eurozone will be hurt as well.
So this leads to the question of Germany in the Eurozone. Since they are predominantly an export driven economy, do they want a stronger or a weaker Euro currency? The answer is weaker, making their exports more appealing to buyers elsewhere. But this is only part of the equation in Germany. They are also (seemingly) the only country with any money in the bank or at least access to credit, loaning to any other Eurozone country who needs cash to pay their debts. While the stereotype of the hard working German supporting the beach-vacationing Greek isn’t as black and white as many would have you believe, stereotypes often upset and influence a populace to demonstrate, riot, or even vote. Germany is getting tired of loaning money out to other countries, and their voting population will soon be demanding an end to it. Even though the weakening EUR is basically helping their economy, loaning out those millions/billions of Euros isn’t necessarily helping them long term.
Because many rich folks and money managers know that this can’t continue, they have started taking a look at how to benefit from a potential departure from the Euro by Germany. Yes, I said Germany. Everyone on the planet who has done more than ten minutes of research into this Eurozone joke knows that Greece, Italy, Spain, and a couple of others may leave at any time, but the question is why would they? If they can keep coming back to Germany for loans, why leave? They won’t until they are forced out. So what about Germany leaving? Are they tired of loaning money out yet? If you understand math and the debt markets just a little, it is apparent that Germany will never be paid back. There are a lot of big time investors who believe that Germany will be leaving, as well as a couple of other countries. How do I know? Look at their bond yields.
What is a bond yield, you ask? It is basically the interest paid on a bond, which is dependent on the price you paid for the bond vs. its issued (commonly known as Par) price. If a five year bond was priced at 100 when issued and paid 5%, if the price of the bond in the aftermarket was 90, the yield would have gone up to ~5.5%. If the bond’s price went up to $1100, the current yield would be ~4.5%. If you take a look at some short term German bonds (two and three years) their actual yield is NEGATIVE. That basically means that you have to PAY them to hold YOUR money. Usually you get paid to loan out your money, but at the time of this writing, you pay THEM. Currently the German two year yields -.056%, you paying them to hold your money. As a comparison, Greek two year bonds pay an astounding 347%! What does that mean? No one wants Greek bonds, as they believe they will not get their money back when the bond is due to pay back the principal. Greek bond buyers are buying lottery tickets, essentially.
By comparison, people seem to want German bonds so much they have bid them up to actually have a negative yield! They are not the only bonds priced like this. Currently there are several Switzerland bonds that have similar yields. So why would anyone pay so much for a bond to receive so little in interest? The easy answer and the one everyone in the financial press talks about is safety, or flight to quality, or risk off. People are so scared of investing they would rather have a guaranteed small loss than a possible huge loss by investing in something else. This is only part of the explanation. One possibility is that if you buy German bonds, what currency will you be paid in if they leave the Euro? A new Deutsche Mark? Very possibly! My personal belief is that this new potential Deutsche Mark would dramatically appreciate (at least for a short time) right after its release. If you hold one of the German bonds, you would make a huge return in the currency fluctuation, if not in the actual bond yield.
So instead of just believing the financial press when they say that bond yields are down because of a flight to quality, consider that these investors may actually be buying a call option on the possible future strength of a new currency! In fact, if the interest paid on the bonds is actually a bit on the positive side, beating inflation even, this is a FREE call option on a potential huge increase in the currency valuation of these bonds.