Interest Rate Spreads (Part II)
As mentioned in the post on the T-bond/T-note spread, interest rate markets have historically provided many good spread trading candidates. They trend well. And when the trend inevitably ends, the spread can often surrender all of the hard-won gains in just a fraction of the time that it took to accumulate them. Even more so when you are dealing with a mean-reverting spread that reached an extreme. Ergo, the old Wall Street saying that “the markets go up on an escalator and down on an elevator”.
Currently, the spread between the Euro bund and the US T-note has our attention. This is an inter-market Treasury trade with lucrative possibilities. We are playing off of the relationship between the debts of two different countries with the same duration.
The Euro Bund/T-note Spread
For the last couple of decades, the Euro bund (10-year duration) and the US T-note (10-year duration) have been highly correlated. This is certainly a testament to just how connected the world economy is. Through booms, busts, and everything in between, the bund and the T-note have pretty much followed the same course and usually at the same time.
From 1999 through early 2013, the spread between Euro bunds and T-notes were stuck in a trading range where the bund would gain several full points against the T-note. Then it would inevitably reverse and come all the way down to trade at a discount of a few points. Wash, rinse, and repeat.
An Outlier…Or a New Trend?
Things changed last year. The Euro bund/T-note spread cleared the price peaks of 2000 and 2005. The spread sold off into Labor Day of 2013, but it still managed to bottom above the 2005 top. For the last year the spread has continued to rocket higher into uncharted territory in the futures markets. In the cash market, the premium on 10-year notes reached a fifteen-year high of 1.45% over the bunds. As a matter of fact, the premium on the US 10-year notes hit a seven-year high against the 10-year Treasuries of their G-7 brethren.
So what gives? Although European and US Treasuries have both been trending higher over the last several months, it is the divergence between European and US monetary policy that has caused the European Treasuries to outpace the US Treasuries by such a wide margin.
About three months ago, the ECB introduced unprecedented monetary stimulus when they cut the deposit rate to minus 0.10%. This is the first time in history that a major central bank has employed a negative interest rate. On Thursday they unexpectedly cut rates again by another 10-basis points, putting the benchmark rate at 0.05% and the deposit rate at minus 0.20%. Even more stimulus could soon be on the way via some Fed-style asset purchases by the ECB. At the same time, the Fed is continuing to taper QE at every FOMC meeting. Yellen & Co. is verbally preparing the markets for an inevitable US rate hike in 2015.
Perhaps now is a good time to mention that famous quote by Keynes that “Markets can remain irrational longer than you can remain solvent”. One should not be lulled into a state of complacency when spreading the financial products of one country against another. When the historical boundaries are tested, there is no law that prevents them from a serious breach.
The End is Near!
OK, so the punctuation for the header should probably be changed from an exclamation point to a question mark. With the spread at multi-year highs in the cash market and all-time highs in the futures market, nobody really has a clue when or even if the trend will reverse. However, there are a few technical setups we can use to gauge a possible trend reversal. Historically, previous bearish trend reversals in the Euro bund/T-note spread have led to multi-year declines. The reward-to-risk ratio on such a trade could be quite lucrative. Here is what we are currently watching for:
On the daily time frame, the most active contract Euro bund/T-note spread has not made a close below the rising 40-day Moving Average since the first few trading days of 2014. Therefore, a close below the 40-day MA could be our first clue that the run is finally peaking out.
Another noticeable pattern on the daily time frame is that the soon-to-expire September contract Euro bund/T-note spread has not traded below a prior month’s low yet this year. The December contract becomes the most active contract this week, so we will focus on the August low of 21.51 for near-term price support. A break below a prior month’s low will alter this bullish price structure and alert us to a possible trend change.
On the weekly time frame, a bullish trend change was signaled last October when the nearest-futures Euro bund/T-note spread closed above the declining 15-bar Moving Average. The spread never looked back. An end-of-week close back below the weekly 15-bar MA would be a reversal signal.
The blog will make a hypothetical trade by shorting one December Euro bund contract and simultaneously buying one December T-note contract if the spread makes an end-of-week close below the rising weekly 15-bar MA. Initially, the spread will be liquidated on a two-consecutive day close 10 ticks above the contract high that precedes the trend change signal.
Note: The risk is a bit trickier to determine on this spread because the Euro bund contract is denominated in Euros and the T-note contract is denominated in US dollars. A full point move in the bund is the equivalent of 1,000 Euros and a full point move in the T-note is the equivalent of $1,000. At the current exchange value of approximately 1.30, this means that the price fluctuations in the bund are about 30% greater in value than the price fluctuations in the T-note. A trader can equalize this by trading thirteen T-note contracts against ten Euro bund contracts. A ‘one-lot’ trader, however, needs to be very aware of how the exchange rate differential is impacting the P/L on the spread trade.