European Bonds Are 2018’s Number One Risk

January 5, 2018

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4 min read

No shortage of stupid things these days:

Bitcoin
Litecoin
Pizzacoin
Canadian real estate
Swedish real estate
Australian real estate
FANG
Venture capital

But European bonds are potentially the stupidest. Maybe even stupider than bitcoin!

You’ve probably seen the charts of European high yield floating around… Yields in the low 2s for BB credits. There was also a European corporate issuer that managed to issue BBB bonds at negative yields a few weeks ago.

I think that might have been the top.

Although there is nothing stupid about it—the ECB has been buying every bond in sight, and there’s lots of money to be made front-running central banks.

How Will the ECB Exit?

Still, it’s possible that we’ve reached the logical limit of emergency monetary policy, and the ECB is going to have to exit sometime in the near future.

The question is: How are they going to exit without blowing up the bond market?

And it’s not just the European bond market. The effects have been transmitted to other bond markets as well, like our own. If the ECB exits, or, heaven forbid, the BOJ tries to exit at the same time—and screws it up—there is a potential for a real meltdown.

What would a meltdown look like?

Fact: Any time ten-year yields have backed up 200 basis points, there has been a crisis. You have to go back to 1994 for the last one. And we even had a mini-crisis in 2013, which we called the taper tantrum.

If tens backed up from 2.3% to 4.3%, it would be a crisis of gargantuan proportions.

What is the probability that it will happen?

Today’s Yields Are Not Worth the Risk

It’s tough to think of these things in terms of probabilities. For example, it’s very probable that the ECB will begin its exit next year. But what is the probability that they screw it up?

It’s literally impossible to handicap. You can’t quantify it. But again: crowded theater, small exit. So you know the unwind has the potential to be disorderly if the ECB is careless about how they exit.

Anyone who has seen markets in action (at least, for a decade or more) knows that selling can lead to more selling, which can lead to more selling, otherwise known as a cascading effect. Nobody under 30 knows what this looks like.

I actually had a very funny conversation with some high-yield guys a few weeks ago. They were laughing at one of their junior traders, who was getting a bit panicked as he watched the index sell off… a point. “This is getting out of control,” he said.

I am not much interested in the bond market until you get tens to 4, investment grade to 7, and high yield to 12. I will turn into High Yield Harry if you get yields out to 12%.

Those sound like impossible levels, but you just have to dream a little bigger, dear readers.

Remember: Cash is an option to buy something cheaper in the future. If yields do get out to 12%, and you don’t have the cash to take advantage of it, you are going to be kicking your own butt all the way down the street.

How to Play When Things Go Sour

It is waaaaay too early to be thinking about this, but…

If you were to try and pick a bottom in the throes of a bear market, it is a lot smarter to do it in the high-yield market than the stock market.

It’s hard to get hurt too badly when you’re getting paid 12–14% to wait for a bottom.

Stocks are a different story. Stocks can go down forever. In 2009, it really seemed like they were going down forever. That is too scary for me.

But I really like buying credit in bear markets and I also like buying converts. Go back and look at high yield and convert mutual funds coming out of bear markets.

You’re talking about 30–40% returns, especially on the lower-quality stuff. On a risk-adjusted basis, it’s a lot better than stocks.

In the meantime, there is nothing to do.

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Jared Dillian

Jared Dillian is the editor of Bull’s Eye Investor, an investment advisory that uses a top-down approach and macroeconomic analysis to identify profitable investments, with a particular focus on behavioral economics. Bull's Eye Investor is a Mauldin Economic publication. Before joining Mauldin Economics, Jared Dillian had a successful career as one of Wall Street’s preeminent risktakers. He started his financial career as a clerk on the floor of the Pacific Options Exchange, where he fetched lunch and ran risk reports and learned everything there was to know about the derivatives markets. After receiving his MBA from the University of San Francisco, he traveled to New York to become a trader for Lehman Brothers. He worked there from 2001 to 2008, bookended by 9/11 and the bankruptcy, first as an index arbitrage trader and then running the ETF desk for a number of years. Under his leadership, Lehman’s ETF effort grew to be number two on the Street in terms of market share and was routinely trading over $1 billion a day in volume.