The bond bear market is back. It’s time to short Bunds.

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  As consensus expects a dovish tapering from the European Central Bank on Thursday, it makes sense to begin shorting bonds ahead of this event. Even if a dovish tapering announcement might not spur massive volatility, we are entering a fragile period for bonds. The selloff is poised to intensify with the German election and a Federal Reserve's tapering before year-end. US Treasuries look even more vulnerable within this scenario than European Government Bonds (EGBs) because the Federal Reserve is clearly behind the curve. Thus, more aggressive tapering will need to follow in the US.


The consensus is for the European Central Bank to begin tapering purchases under the PEPP Program this quarter and be announced as soon as this Thursday. If that were the case, the ECB would lead the Federal Reserve to end accommodative monetary policies.

That would be a clear signal that the bear bond market has begun and that it is time to short Bunds and Treasuries. However, how to do that?

We will talk about that shortly. First, it's essential to understand what is at stake during this week’s ECB meeting.

  • Economic outlook revision Following a robust second quarter, the ECB will certainly need to revise projections for this year. However, would it change growth and inflation for 2022 and 2023? That is crucial because if the central bank revises inflation upwards for the next two years, it will signal that inflation is more permanent than expected. Yet, such a revision would be more significant for US Treasuries than for EGBs. Indeed, contrary to the US, inflationary pressures would still be expected to undershoot the ECB's target after this year. In June, the central bank expected inflation to come at 1.5% and 1.4% in 2022 and 2023. A slight revision upward should still place expectations below the ECB target of 2%, meaning that monetary policy will be less accommodative in Europe but still quite loose in the long-run.
Source: European Central Bank.
  • PEPP and APP program. The PEPP program was created to stimulate the economy in the wake of the Covid-19 pandemic, and the official deadline is March 2022. The question here is whether the central bank recognizes that we are out of the pandemic period and believes that the economy doesn’t need stimulus anymore. Yet, the Delta variant might weigh in that decision. If the PEPP program ends in the first quarter of 2022, the question is whether the APP will be modified to partially substitute the PEPP. This information is critical for rates because it will imply more or less support for EGBs.
  • Financing conditions. One of the most significant focuses of the ECB this year has been to maintain financing conditions loose. Yet, since the market started to speculate about tapering, rates began to rise with Italian 10-year BTP gaining 11bps in six trading days and 10-year French OAT turning positive for the first time since mid-July. While it is true that financial conditions remain extremely easy, a fast adjustment of rates higher might tighten conditions suddenly. That's the main reason why any announcement from the ECB needs to be dovish. Hence, the market expects a "dovish taper", which should limit market volatility.

It's easy to conclude that whatever decision the ECB will take to taper purchases under the PEPP program, it will try to deliver it dovishly. It’s up to the market to interpret whether the dovish framework that the ECB presents is dovish enough. However, if it works, volatility can be contained. Yet, it's impossible to ignore that times are changing fast. Suppose an announcement over the PEPP is not presented now. In that case, it must be tackled in December, adding more pressure on rates, which will be even more volatile following the German election.

Additionally, if a dovish taper is delivered on Thursday, the biggest loser might still be US Treasuries. Indeed, the Fed is falling behind the curve, and the longer it waits to taper, the more aggressive it has to be. That's why this is also the right moment to short US Treasuries.

Using options to short Bunds and US Treasuries

It is relatively easy to short Bunds and US Treasuries through options. Expectations are for interest rates to rise, thus falling bond prices by the end of the year. If you are long put options, you have the right to sell a bond at the strike price, exposing yourself to a limited downside (premium) and unlimited upside.

In the Saxo platform is possible to browse options by uploading the ticker and clicking on “Option Chain”. The ticker for the Euro-Bund is FGBL, while for US Treasuries, it is ZN.

Let’s take the Euro-Bund option with the December expiry as an example. We like the December expiry because we expect yields to accelerate their rise during the last quarter of the year.

Source: Saxo Group.

The cost of a put option with delta -0.22 today is of 0.470. Because the size of the option is 1,000, the total premium to put up to buy the put option is 470 EUR.

Similarly, the premium to pay for 10-year US Treasuries put options with a delta of -0.23 is 390 USD. 

Source: Saxo Group.
Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo Capital Markets HK Limited holds a Type 1 Regulated Activity (Dealing in securities); Type 2 Regulated Activity (Dealing in Futures Contract) and Type 3 Regulated Activity (Leveraged foreign exchange trading) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong

By clicking on certain links on this site, you are aware and agree to leave the website of Saxo Capital Markets, proceed on to the linked site managed by Saxo Group and where you will be subject to the terms of that linked site.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

Please note that the information on this site and any product and services we offer are not targeted at investors residing in the United States and Japan, and are not intended for distribution to, or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. Please click here to view our full disclaimer.