By Walter Kurtz From The Trading Floor

German bunds selloff may be overdone
Luxembourg tax policies boost ‘shadow banking’
China undertakes ‘stealth’ easing programme

Let’s begin with a quick look at the recent sharp correction in German government bonds. Fundamentals suggest that the 10-year yields should be even higher. The chart below shows the comparison with the Deutsche Bank regression model versus PMI, inflation, and US yields (grey). Quantitative easing purchases, however, will continue to put downward pressure on yields.

German yield

Regression against inflation expectations (implied by the inflation swap market) seems to show that the 10-year bund yields are roughly where they should be.

Inflation swaps

And on the short end of the curve the selloff seems to be overdone. The chart below shows the forward Eonia (overnight rate) curve (now and two weeks ago). As DB points out, the curve shows the first non-zero probability of rates moving higher as early as the end of this year (versus September 2016 two weeks ago).

This is completely inconsistent with what the European Central Bank is telegraphing and is likely to extend out again. That means short term bond yields in the Eurozone (particularly Germany) should decline.

Eonia curve

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Staying with the Eurozone for a moment, there has been some discussion recently about why Luxembourg runs such massive “shadow banking” balances. Part of the reason is that it is a “tax friendly” jurisdiction.

If you are a Cayman-based credit fund lending to a firm in the UK, the UK tax authorities will withhold taxes on interest (because there is no tax treaty between the Caymans and the UK to avoid this tax). To address this, one sets up a Lux vehicle that passes the loan through to the UK company (Luxembourg has a tax treaty with the UK). Luxembourg authorities take a small cut and voilà – a Cayman entity is lending to a UK company.

Shadow banking

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Some have asked whether Switzerland’s central bank should undertake some monetary easing measures, given the deflationary pressures the nation faces (discussed last week). The Swiss National Bank however is paralysed.

The central bank’s balance sheet is already massively bloated. It holds an unprecedented amount of euros (FX reserves) which have depreciated significantly. In fact, relative to the Swiss GDP, the size of the balance sheet far exceeds most other central banks.

Should it begin purchasing Swiss securities at negative rates and incur further losses?

SNB Balance Sheet

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In China everyone is waiting for the central bank to announce more easing actions. But it’s not what the People’s Bank of China is saying that matters to the economy as much as what’s actually going on in the short-term rates markets. And short-term rates continue to fall. This is a form of easing without the central bank announcements.

SHIBOR

Note that even the one-year SHIBOR, to the extent it represents an actual lending rate, is also falling (though remains elevated relative to inflation).

SHIBOR

One of the reasons China needs to lower market rates is to help strapped municipalities refinance their debt. Currently a great deal of the debt is structured using off balance sheet bank products and Beijing’s goal is to shift to the muni market. That process will take some time.

For more on this story go to: https://www.tradingfloor.com/posts/daily-shot-the-corrections-4757653