Bonds & Bunds
Today we will look at the bond market and how it relates to other financial markets.
Bonds as an asset class will always be needed, not just by governments, insurance companies, and pension funds, but by aging boomers. I consider myself a young lad who has only been in the market for a couple of years.
This year I always said bonds are the dumbest investment, never paid attention to them, and never really gave a damn about them. While I matured in the market, I was told by people smarter than me that the bond market is the most important asset class in the world, and when it speaks, you shut up and listen. As a degenerate, you might ask yourself why I should listen to the old man yelling at the sky. Did you ask yourself why the old man is yelling at the sky? So, let’s ask why we would listen to the bond market.
The best start to learning more about the bond market is here. The only 2 significant things I want you to understand 1. When bond prices go up, the yield of bonds goes down, because everybody wants them. The inverse is the same: when bond prices go down, the yield goes up because nobody wants them. 2. Interest rates are the most important driver of bond prices and bond yields.
The bond market is the global credit market where individual governments can lend and borrow money. There they can create debts as their principal activity or buy and sell debts as their secondary market. These debts are usually presented as bonds, and they are used to give long-term funding to different financial projects. This means that governments start printing money and using it to fund projects. You’re probably thinking to yourself; the government is just a degenerate. The difference is that if you get liquidated, nobody cares; if a government gets liquidated, all hell might break loose.
As a trader AND investor, you should pay attention to this market to evaluate future changes in the world's economy.
At the time of writing this, the economies worldwide are changing. You are seeing Dutch farmers protest the government; the Sri Lankan government has announced they are broke, and the US government is funding the Ukraine war with taxpayer money. What I want to dive deeper into is the ECB. Being a central banker right now is hard; everybody criticizes you. The Euro is trading 1/1 with the US Dollar, which hasn’t happened in decades. As an individual that is paid in dollars and living in Europe, it's GREAT. For your average Jane and Joe, it isn't the best. How did the ECB let it get this bad? Well, several things have influenced this.
Well, if you studied economics in high school, you’re thinking that a weakening currency isn’t bad as it stimulates economic growth since exporting products is cheaper for the world. The problem for us Euro bros is with inflation in the eurozone at its highest since they began taking record of it, its weakness is undesirable as it fans price gains by making imports more expensive. In October, the annual inflation rate in the Euro Area jumped to 10.7%. Some policymakers have highlighted a weaker euro as a risk to the central bank’s goal to return inflation to 2% over the medium term.
The ECB is the central bank of the 19 European Union countries, and I want to look at Germany and Italy. A group or organization is only as strong as the weakest link. According to experts, when inflation is peaking, the best investments are bonds because they are a safe haven, and the chance of governments defaulting is low (you think everybody should buy bonds, and yields should be down). Wrong, Euro yields have been consistently rising, and the most robust economy in Europe, Germany, has lost a fifth of its value in six months; it is typically a sign of distress on the borrower's part. Italy’s 10-year bond yield has 4.4%, its highest level since 2014, and quadrupled where it started the year. The spread between these two countries is essential. First things first, what is the spread? The spread has been used to describe the difference in the value of 10-year BTPs (Italian government bonds) and German 10-year Bunds issued and traded on the secondary market.
Why is the spread so important?
Comparing Italian government bonds with German Bunds, considered more stable, shows the confidence markets have in Italy. The reason for this is simple: as sales increase, the bond yield rises, and their price decreases. If there are fewer sales of German Bunds at the same time, there is less confidence in Italian bonds, and the spread widens. The spread acts as a risk premium on the euro; when uncertainty increases in the Eurozone, you will see a rise in the spread, which leads to a decrease in the euro. The inverse is the same.
The consequences of a high spread
The effects of the spread on the national deficit and public debt are not immediate, but they are seen when the next BTP is issued. If the spread is high when a new BTP is issued, the new bonds will probably adapt to the performance of the secondary market, costing the government more. A BTP-Bund spread may also affect businesses and households, not just the government. Indeed, a high spread mostly likely translates into higher interest rates. Banks would suffer the consequences, as they would then be forced to pay more to raise funds and earn less on the government bonds they own, driving them to charge more for financing and loans.
The closing of spreads is fundamental because of the role of government bonds in central banks’ open-market operations and their distinct quality as safe assets. This makes government debt the backbone of most fixed-income security markets. As safe assets, government bonds provide the benchmark yield curve for other securities and impact the trajectory of the overall credit curve in the economy. In other words, government bonds price and influence any security issued in the market.
The BTP-Bund spread is just an example. In the international business community, the yield differential between German government bonds and those of other countries less financially sound than Germany (e.g., Italy) is considered a kind of barometer for measuring turbulence. When there are phases of instability in the markets, the spread goes up.
Financial markets are large and confusing. That's why it is crucial to observe the relationship between financial markets. This not only makes the bigger picture clearer but can also lead to more intelligent trades. Crypto degenerates might be asking themselves how government bonds impact the future of finance. Well, let me tell you that the most critical factor is that bonds and crypto tend to move together right when inflationary pressures and interest rates are low.
Usually, central banks are committed to low-interest rates to stimulate the economy during recessions. This lasts until the economy grows without the aid of monetary policy or capacity utilization reaches maximum levels where inflation becomes a threat. Central banks cannot lower interest rates as they are already deficient. They need to raise them to bring inflation down. This is quite a conundrum for central banks, and I don’t want to be in their shoes. They raise interest rates and kill demand. They don’t raise interest rates, and inflation goes higher. Damned if you do and damned if you don't.
Inflation is exceptionally high, and central banks are forced to raise interest rates; The BTP-Bund spread currently shows considerable uncertainty, reaching its highest before a recession. We are heading for a recession, and to get out of it, you must cut interest rates, but they can’t because inflation is too high. We are in a death spiral, damned if you do and damned if you don’t. What can you do as an investor with no understanding of the market? I would stay in cash and hold dollars. Some fund managers are inclined to remain to invest their clients' money and are only focused on three-month US government bills yielding 4%. There will be talks from the government months before they pivot. When they pivot is a whole other article.
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