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Bund lifeboat sails off, rest left to arrange the deckchairs

View: Bunds still the only viable defensive play, 1.55% yields beckoning

We’ve been bullish bunds since the start of the summer on expectations the Eurozone crisis will get worse before it gets better.  Unfortunately for those living in the region this prognosis was spot on, and there is still looks no end in sight with glaring splits within the block clear for all to see.  To make matters worse the breadth of problems continue to grow with each new euro bailout plan proving too little too late – exposing the flawed political structure of the EMU project as much as those of the single currency itself.  Indeed, the Greek bailout proposed back on July 21st looks doomed to fail even before it’s off the ground; not that its structure was all that viable in the first place.  The ECB meanwhile has been forced into buying Spanish and Italian debt to prevent a total freezing up of these two key markets as investors voted with their feet, exposing its vocal independence as something of a fraud (not a criticism unique to the ECB we’d add).

Last weekend’s State elections in Germany have further complicated the already chaotic situation.  Defeat of Angela Merkel’s coalition block in her own State - despite heavy campaigning by her personally - can be attributed directly to her mishandling of the crisis in the eyes of voters.  Given that Federal elections are due next year the concept of Germany pushing for any form of consensus based solution looks more and more improbable.  Self-preservation will become the goal.

Politics aside, economic pressures are spreading with a clear deterioration in conditions across the block in July and August following from an already disappointing Q2 GDP performance.  If powerhouse Germany is faltering what hope is there for those being forced into further austerity.  Of course it is easy to say growth should be the priority – the truth is the crisis is now so mature that even this is no longer a viable strategy – after all who would lend to enable these governments to pursue growth policies.  So it’s back to that question of which countries are already insolvent and which are guilty by association and of those which can still escape.  12-months ago this would have been a fairly straightforward question but now the shades of grey continue to spread and with it the ultimate cost (see chart above).

As the death throws play out (it may take a while yet) perceived safe haven assets will continue to find buyers – forced or otherwise – with bunds set to be the principle beneficiary.  We anticipated sub 2.00% bund yields in are article of August 3rd, the weight of demand though has already seen yields gap below here.  The next target level on a cash basis is 1.75% but the principle draw should be 1.55%.  Looking at the political and economic realities this looks easy to justify, factoring in uncertainty/panic over the future of the entire euro project even more straightforward.

In futures terms, pushing on from already record highs, the psychological draw is the 140.00 level (RX1), above there lies strong weekly resistance currently at 140.24 (rising approx. 10 ticks per wk) which looks a more robust target.  Higher projection levels from the weekly continuation chart point to as high as 145.03 by year-end but we’d expect to see a decent retracement before a leg towards here, even if this is just due to increasing volatility/panic and the political reactions these trigger.  The first decent initial support area comes in at 136.18/26 on the daily chart now although we’d need to see 133.88 fail to confirm any more permanent top is in place and expect buyers, if given the opportunity, to use such dips to continue to accumulate.

We mentioned on Friday in our payrolls article we like curve flatteners in the US and the same logic also applies to the German curve although the market is a little further down the line here.  But given the deflationary policy mix at work in the Eurozone and ECB’s tolerance for aggressive monetary policy the foundations for the flattener are even better.