The best trade of the week in Paris was the one nobody put on. At L&G Asset Management in London, fund managers looked at French government bonds after the first leg of the selloff and saw a gift: a spread over German bunds they hadn’t seen in years, plus the quiet tailwind of roll-down (as a five-year bond ages into a four-year, its spread usually tightens). The firm’s rates strategists vetoed it. Too many investors were still long France, they argued, and a crowd heading for one door at the same time makes its own stampede. Thursday’s disorderly selloff settled the argument. John Roe, L&G’s head of multi-asset allocation, told the Journal’s Joe Wallace it’s “very tempting when you see numbers you’ve not seen for a long time” to dive in.
The trades that blew up were carry trades — Wall Street for borrowing in one market to buy in another. The popular version: own French and Italian bonds, short German bunds, and collect the yield gap while waiting for it to narrow. A second version bought French and Italian paper and sold interest-rate swaps against it, stripping out the rate bet and leaving a pure wager that a country France’s size wouldn’t default inside two to five years. Both assumed the gap was already wide and bound to come back in. Instead it widened — a shift in presidential polling, a poorly received budget and a global government-bond selloff all piled up at once — and SMBC’s Hank Calenti says the intra-Europe carry trade “has gotten crushed.”
Why so violent? Ownership. France’s €3.5 trillion bond market — about $3.9 trillion — is the largest in Europe after years of deficits, and more than half of it, by MUFG’s count, sits with foreigners, who have less reason to hunt for yield in Paris now that they can earn it at home or in Germany. Short-term French yields swung as much as 0.40 percentage point over two days; Calenti’s read is that a slow bleed turned into a rout once risk managers started tapping shoulders. The spread over bunds hit 1.55 points Friday; the record, from November 2011, is 1.81. RBC BlueBay’s Mike Bell thinks ratings firms could downgrade France.
The number you haven’t seen in years
Here’s where this stops being about France. Pimco’s Konstantin Veit says hedge funds are unwinding carry trades broadly, and France is just one leg of them. The behavioral trap is universal, too: a yield that looks historically high is high for a reason, and the reason can deteriorate before the European Central Bank — which some investors count on as the eurozone’s ultimate backstop — decides it has to act. By Tuesday’s close the French 10-year was 4.755%, versus 3.497% for Germany and 4.530% for Italy.
Our read
This is Fixed Income (IN02) with a Behavioral chaser. The French lesson is the one the desk has been living for a month: long duration is where a rate shock does its damage, and ‘cheap’ isn’t a price, it’s a direction. Our stance hasn’t changed — safe money in Treasury bills and floating-rate paper (SGOV, held in 49 books, and USFR, held in 14), long Treasurys avoided. TLT sits in just 4 books, and Tuesday’s table says why: 77.28, down 11.3% for the year, while SGOV was up 0.1%. Nothing added anywhere.
The L&G story is also a governance story. The fund managers weren’t wrong about the math; they were about to be early, which in a crowded trade is the same thing as wrong. Someone with no position had the standing to say no — and that’s what a written investment policy does for a household. If a yield this fall has you wanting to lock it in, check whether the lock is on the yield or on you. Fifteen minutes with the fixed-income sleeve now beats learning what duration means in a downpour.