The forex playbook if bonds continue to burn.
"I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody." - James Carville.
The bond market is the driving force in every market at the moment. The single-most important asset at the moment is the Germand Bund, which fell to an all-time low of 0.05% last month but rebounded up as high as 0.738% today (but has slid back to 0.675% in choppy trading).
German 10-year bund yields - one month chart
There are two big questions to consider before we talk about what it means or forex. The ultimate one is whether this is the end of the 30-year bull market in bonds. I've joked many times about how betting against bonds has widowed the wives of many traders. False turnarounds in rates have occurred many times before and whether or not the momentum is sustained is tough to say. I struggle to see them rising too high with the ECB buying €60 billion a month.
The second question is if direction is even the most important takeaway of the recent bond moves. What might matter more is volatility. With so many assets tied to bonds, a higher volatility environment will spread to everything. Volatility breeds contempt and I can't help but thinking that means a spell of risk aversion. The conundrum is that the soul of the risk-aversion trade is buying bonds.
So my base case is that we continue to see yo-yoing rates in a higher volatility environment; rather than a pure bond selloff.
Three ways to trade it in the forex market
1) Euro longs
It works both ways. If Bund yields continue to rise it's a great trade. But what continues to amaze me is the extreme level of euro shorts in the CFTC report. It argues that it's still a very crowded trade. Even if bund yields don't continue to rise, higher volatility will shake those shorts out. The recent slide in the euro has been EUR/GBP selling and it leaves the euro in a tempting spot on a few crosses.
2) Kiwi shorts
The New Zealand dollar is the ultimate carry currency. In peaceful markets, money slowly flows to NZD-priced debt. Parts of the trade have been cleared out by the fall in NZD/USD over the past 8 months but NZD/JPY longs and EUR/NZD shorts made most-any time over the past 5 years are still well into the money.
When the carry trade clears out, it can happen violently. In the crisis, NZD/JPY once fell 14% in a single day. Yesterday's 2% fall in the kiwi was blamed on speculation about RBNZ rate cuts but that's only part of the story. The bulk of it is that tremors are hitting the carry trade.
3) USD/JPY longs
This is less of a trade on volatility and more on bond direction. A smoother rise in Treasury yields along with the technical setup in USD/JPY points to another leg higher in the pair.
Keep in mind that the sovereign bond rout is a bit of a misnomer. Not all bond are equal and not all yields are rising at the same pace. The Bank of Japan virtually has the domestic market cornered. JBG yields moved up 5 bps today and that's kept a lid on USD/JPY today but of all the sovereign markets, it's the least-likely to extend higher.
