The World's Biggest Steepener

It's been a while since I have written about German bunds and other nuttiness in the European fixed-income markets. Although I am still long-term Kodiak-grizzly-bearish on European bonds, I have had the good fortune to make friends with Mattia Parolari from Barclays Bank in Paris. Mattia is an institutional rates strategist specializing in European fixed-income. We have had numerous Bloomberg chats where he has patiently explained the problems in European fixed-income markets, but more importantly, highlighted the structural mismatch of liabilities versus assets in European financial firms' balance sheets. Unfortunately, I come to no Cramer-like conclusion (neither BUY-BUY-BUY nor SELL-SELL-SELL) from the following analysis, yet it's fascinating stuff that sheds light on the gong-show that is European fixed-income.

Let's review where we stand by having a gander at the chart of the German 10-year bund yield over the past year:

(Click on image to enlarge)

Last January, the yield was hovering at a still-obscene +25 basis points, but at least it was positive. Then, due to a whole host of reasons (but in my opinion, mostly due to the Fed's mistaken tightening of financial conditions), yields collapsed in Germany. The decline in yields started slowly, pushing below 0 basis points in March, but then July rolled around. In a sickening swoosh, the 10-year German bund yield fell from negative 20 basis points to negative 75 basis points.

A lot of market participants still do not fully appreciate the downward crash in European bond yields that occurred last summer. It was epic. 

The real question to ask is why?  Did the prospects for the German economy deteriorate enough to justify a decline in 55 basis points in less than two months?  Was minus 75 basis points the correct price for 10-year German debt?  

Well, unless you believed German inflation will not be inflation, but instead deflation of more than 75 basis points for the next decade, bunds were a terrible investment. It's tough for me to even begin to describe the absurdity of this anomaly. It's like Dumb & Dumber were put in charge of bond pricing. Don't even get me started on the CNBC-portfolio-managers who this summer somehow advocated buying bunds on the belief that they could go even more negative!  Yeah sure, it could happen. But at that point you are no longer a portfolio manager. You are just a degenerate river-boat-gambler. There is zero fundamental argument for locking in negative nominal rates (and even greater negative real rates) for ten years. 

Yet you could have said this at zero basis points, and then the same at minus 10, minus 20, etc... Someone must have been buying the bunds at all these absurd levels. It can't all be BlackJack Snoopy's driving bunds to the moon.

This is where my discussions with Mattia shed light on the situation. Let's grab one of his charts from the EIPOA report. This governing body's acronym stands for the European Insurance and Occupational Pensions Authority. They survey members to understand their liabilities.

(Click on image to enlarge)

At first blush, their liabilities look fine. Most of them are centered near the front of the curve. However, this is where Mattia's hard work kicks in. When you calculate the duration adjusted liabilities, a huge glaring hole becomes apparent.

(Click on image to enlarge)

These financial institutions are stuffed to the gills with 50-year+ duration risk!

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Disclosure: None.

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