The Euro Bund/T-note Spread
Previously, the blog has demonstrated that a strong correlation exists between the Euro bund (10-year duration) and the US T-note (10-year duration). We have also shown that periods exist where the two markets diverge or alternate leadership. In some cases, this pushed the spread to historically unsustainable levels where the knowledgeable trader could prepare to capitalize on a reversal. It is possible that we are seeing this occur right now.
Fundamentally, we are still seeing a divergence between European and US monetary policy. While the question over here is one of “when” and not “if” the Fed will start hiking rates, the ECB continues to operate in a negative interest rate environment as there seems to be no light at the end of their economic tunnel. This is the catalyst that drove the European 10-year yields to multi-decade lows against the American counterpart and put the spread at a record high. However, history indicates that this will not last forever. If the Euro bund/T-note spread rolls over again, it would suggest that the divergence in monetary policy may be coming to an end.
A Second Chance?
In the first quarter of the year, the Euro bund/T-note spread peaked out at new all-time highs. The reversal that followed was quick and volatile. Traders who did not act immediately were left in the dust. But after bottoming out in mid-June, the spread began a major bear market rally. This put it back on the watch list for a potential short sale.
On the nearest-futures chart, the Euro bund/T-note spread recently closed back above the 100-day Moving Average for the first time since April. When the 100-day MA was decisively broken in April for the first time in over sixteen months it led to the dramatic decline. The current rebound to the 100-day MA puts the spread at a decision point. This is either where we see confirmation that the selloff was merely a sharp correction in a multi-year bull run or else we should see another reversal and expect a new decline to a lower low than what we saw in June.
From a technical view point, the Fibonacci .618 retracement of the entire decline should mark resistance for the current rally. That level is located at 28.46. Although the nearest-futures spread has not yet reached this level, the December Euro bund/T-note spread has. This would be an ideal place for the summer rally to end.
The blog will make a hypothetical trade by shorting one December Euro bund contract and simultaneously buying one December T-note contract if the nearest-futures spread makes a two-day close below the 100-day Moving Average (currently at 27.00) or the December spread breaks the August 5th low of 27.44. Initially, the spread should be liquidated on a two-consecutive day close 10 ticks above the high of this current rally from the June low.
Note: The risk is a somewhat of a moving target since 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 equals 1,000 Euros and a full point move in the T-note equals $1,000. At the current exchange rate of approximately 1.105 the price fluctuations in the bund are about 10.5% greater in value than the price fluctuations in the T-note. A large trader can equalize this by trading eleven T-note contracts against ten Euro bund contracts. A ‘one-lot’ trader, however, needs to stay aware of the how the exchange rate differential is impacting the P/L on the spread trade.