Bund-watching

Watch those Bunds — and US Treasuries — for signs of the Europe crisis spreading.

The spread of eurozone peripheral debt to German bunds (think here, here, or here) has become the early warning indicator for sovereign stress/contagion. But not many have actually stopped to look at the comparing figure — Bund spreads. Germany is, after all, the EU member most on the hook for bailing-out its Club Med cousins.

From RBS’s Bill O’Donnell on Thursday (links/emphasis our own):

In a recent commentary I highlighted that we had a 10Y Bund auction that only covered (1.2X) because they sold only EUR 4.76B of the EUR6B on offer. Thus, the ‘real’ Bid/Cover was 0.94X. After I published I later tripped over this interesting observation that came courtesy of Andy Chaytor in European rates strategy: “The widening in [EU] CDS is broad-based. Relative to a starting point of 34bp, Germany widening 10bp is a big move. We are not yet at the stage, we think, of looking for Bunds to perform badly based on what is happening in other parts of the market, but spreads to the US need to be watched very carefully. Any sign of widening to Treasuries in CDS AND cash is a sign that the crisis is going to a whole new level.”

I find this observation especially interesting in light of their expectations that EU sovereign issuance will experience a seasonal surge in 2011. The last numbers I saw from them indicated that roughly 45% of 2011 issuance will hit during Q1 and another 30% in Q2. We need to keep an eye on Bunds and Wednesday’s trade was perhaps a good example since the Treasury sell-off really gathered steam after the Bund auction results came right at our open.

Also, John Briggs and I do a survey of market conditions every week for our friends on the regulatory side. I survey traders and strategists in different markets to see what flows and dealing conditions are like. Almost everyone I spoke to on Wednesday complained about significantly deteriorating liquidity. The mortgage market is now a bifurcated market with high coupons (4.5′s and above) trading like gold and current coupons (4′s and 3.5′s) trading mostly on the bid side.

Positioning is still a problem in this market (the down-in-coupon trade was seen as a proxy for a bull flattener) and year-end unwinds and rumours of an MBS Fails Charge don’t help. In Agencies, the callable market has dried up as rising realized and implied vols have caused dealers position pain while investors sit on hands and wait for conditions to stabilize. The swap market is being buffeted by large trades and huge swings in Euro$ and the Vol market (Gamma) has gone bid with no new supply of Vol. So my survey suggests that position imbalances remain and that the two day respite from the post-QE2 heave-ho (Monday and Tuesday) was just that, a brief respite.

Grausig.

Related links:
Wednesday Unglück: the Bobled German bond auction – FT Alphaville
Friday’s ‘interessant’ eurozone bond trade – FT Alphaville
Germany’s Bank-Asset-Berg - FT Alphaville