Zero Hedge has long been bearish on the prospects for the German Bund, whose yields at 50-year record lows, can only go up. Couple this with German CDS which still inexplicably trades inside of the US, and the fact that the PIIGS fallout is certain to wreak fiscal and/or monetary havoc on the core of the Euro zone, or alternative a favorable resolution is sure to end the Bund flight to safety trade. We have discussed both Bund short and German CDS long positions for those readers who can establish such exposure. Yesterday afternoon, Morgan Stanley's European Interest Rate Strategist came out with a Bund short call along precisely the same fault lines that we have uncovered in Europe's shifting te(c|u)tonic lines.
On the cash bond side looking at countries like Spain and Portugal there is the risk that the market forces take over and start to push spreads wider and spread curves invert as we have seen happening in Greece. However, we think that Greece Portugal and Spain all appearing to be in trouble is a very different proposition to just Greece in trouble. In that scenario we think that core countries may start to come under pressure. A much lower-beta way of playing the current market is to short 10- year Bunds. [The chart below] shows the 10-year German benchmark, which is at 50-year lows. Germany benefits from a flight to quality bid but this may not be the case if Germany is considered the backstop of Europe. Equally if the current situation gets resolved, then Germany should lose the flight to quality bid and we should see a transfer of risk out the credit curve and we would expect to see Bund yields rise. In our outlook for 2010 we suggested that yields would be higher but that it was expensive being short and so it was important to play the range. We think this is a good opportunity to get short 10-year yields.
Sell Protection on SovX versus Germany
An alternative way to play this in CDS space is to sell protection on SovX versus Germany. [The chart below] shows the iTraxx SovX on the left hand side and the SovX weighted basket on the right hand side. We look for an entry level of 80 bp to get into this trade. This trade works well in the scenario that markets start to believe the rest of Europe will have to support other countries or it will work in the scenario where the market starts to believe in a more positive outlook for countries like Greece, Spain and Portugal.
The Bund trade is truly a no-brainer, with both a good and bad PIIGS outcome set to push yields north. And soon to be discussed on Zero Hedge - currency pegs got you down? Want to express an opinion on China but PBoC not letting you manipulate the renminbi? Don't fret - play the relative trade using China CDS. All the FX guys are doing it.