January 29, 2019

As the soft (EU-deal) Brexit or hard (no deal) Brexit deadline approaches at the end of March, one has to keep an eye on the euro and major European bond markets, since Brexit, by definition, has weakened the core of the European Union and the eurozone, even though technically Britain is not part of the euro.

The failure of Britain to join the euro stems from George Soros, who benefited handsomely from its withdrawal from the European Monetary System in 1992. I find it rather ironic that a brilliant trader like Soros helped force Britain out of the EMS quite profitably, yet Soros the philanthropist has been one of the most outspoken opponents of Brexit! If the philanthropist had overpowered the trader’s instinct and Britain was part of the euro today, it is entirely possible that there would not have been a Brexit vote.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Still, with Brexit approaching, the safest government bonds in Europe – the German bunds – closed last Friday with yields of just 0.19%, or 19 basis points (in bond traders’ lingo). It is true that Germany had some rather disturbing economic data, as its industrial production fell 1.9% in November for a third consecutive down month. France, on the other hand, had a populist outburst in the face of the “yellow vest” movement, and French government bonds closed Friday with a yield of just 60 basis points (0.6%).

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

One reliable indicator of the level of financial stress in the eurozone – recalling the days of the old eurozone crisis in 2011 – was the so-called Franco-German spread, which can expand considerably more than its present level of 41 basis points. This would be a good indicator of where things are headed in the eurozone, as well as the government bonds yields in Italy, where a stagnant economy and high debt levels brought a euro-sceptic government into power. The spike in Italian government bonds in 2018 is called a “deflationary” rise in interest rates, since it reflects the fear that the Italian bond market will not clear, based on the government budget fight with the EU and its ongoing desire for massive deficit spending.

I think that any Brexit, hard or soft, is bad for the EU and the eurozone. I suppose a soft Brexit is better than a hard one, but the withdrawal of Britain leaves the eurozone and the EU weaker and vulnerable to dissolution. For example, the EU could not survive the withdrawal of Italy, which (given its stagnant economy) has chosen to put a euro-sceptic government in power.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I find it fascinating that the German 2-year federal notes that go by the name “bundesschatzanweisungen” (dubbed Schätze notes, to avoid tongue injuries) closed at -0.59% on Friday. The Schätze notes never got out of negative territory after they finally declined below zero in late 2014. To me, the negative-yielding Schätze say that Europe never got out of the woods when it flirted with deflation in 2015 and 2016. The negative-yielding Schatze notes say that the risk of dissolution of the eurozone never disappeared.

Whatever Happened to “The Short of the Century”?

In 2015, Barron’s ran a column in its “Up and Down Wall Street” section called “German bunds: The Short of the Century.”  The article quoted both Bill Gross of PIMCO fame, and Jeffrey Gundlach of Doubleline Capital expressing negative views on German bunds. Bill Gross focused on the 10-year bunds, while Jeffrey Gundlach focused on the negatively-yielding Schätze notes. Both used very strong language to describe their views on this “short of the century” or “the short of a lifetime.”

It turns out that neither the bunds nor the Schätze notes were very good short ideas, as the bunds are again flirting with negative yields (19 basis points above zero) and the Schätze never left negative territory.

The German bund performance tells me that the problem of eurozone deflationary pressures is very serious and it is probably not confined to the eurozone. It certainly exists in Japan and may later show up in China, where the credit bubble created by 25 years of lending quotas gives all indications of bursting.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Any eurozone deflation is good news for U.S. Treasury yields, as they are the highest of any developed country, so U.S. bonds will see strong demand. Despite record issuance of Treasuries in 2018, to the tune of $1.3 trillion, and the balance sheet unwinding by the Fed, it is entirely possible that we saw the highs of 3.25% of 10-year Treasury yields for this cycle, and it is all downhill from here for Treasury yields, although a retest of 3.25% cannot be ruled out later in 2019, based on the record issuance planned.

In the next recession in the U.S., whether that is in 2020 or 2021, I expect U.S. 10-year Treasury yields to drop to 1% or lower due to deflationary pressures and unorthodox central bank monetary policy. This should be good news for conservative dividend strategies and quality corporate and municipal bonds.

About The Author

Ivan Martchev

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. *All content of “Global Mail” represents the opinion of Ivan Martchev*


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