The Trade for 2017 @ Wall Street

The Trade of 2017:

The three most recommended trades for 2017 with market consensus are that most brokerage houses are recommending …

The first possible trade is buy US banks this year and it will bring you great wealth. The second possible trade of 2017,  is to sell short overvalued consumer staple stocks.  But the single most compelling trade that I feel would work out very well   is to buy German government bonds.

 Why could you possibly want to buy debt that offers a minuscule or negative yield? Surely only a fool would pitch such an idea is what most people would think.

Conventional wisdom has it that to buy German government debt is at best unimaginative and at worst brainless. Bond yields are low because growth in the Eurozone and inflation expectations are subdued and interest rates are likely to remain low for many years to come. To buy fixed income securities that offer such a poor return is viewed as a sad admission of investment defeat, as though the best that can be hoped for is to get your principal back more or less in one piece.

Looking at it in a different way, the apparently dull investment is one of the most mispriced opportunities on offer. The investor who buys Bonds today is in fact taking out a compellingly priced and highly asymmetric bet on the break up of the Eurozone at some point before the bond comes to maturity.

The logic behind this trade is as follows. Although it is impossible to quantify, there is a risk that the single currency will split, whatever form the break-up would take. What can be stated more certainty is that in such an event a future German currency, call it the Deutschmark 2.0, would trade at a far higher level against rivals than the euro.

Germany’s current account surplus as a percentage of gross domestic product has risen steadily since the adoption of the single currency it was 8 per cent last year and its current account has strengthened relative to that of the US. A standalone Deutschmark should trade at a significant premium to the euro when priced in US dollars.

In the event that a German currency was set free from the artificially low single currency, the value of the redenominated German government debt should appreciate significantly. This means anyone buying Bonds today is in fact buying an embedded option on this potential future appreciation.

The question is how aware is the wider market of the existence of this embedded option, and what value can be ascribed to it?

Unlike a regular option, buying German government bonds does not involve paying an expensive premium and losing money to time decay. A 10-year Bond can be purchased today at a yield of 0.3 per cent, meaning that a position can be held for a decade with a positive cost of carry, at least in nominal terms.

A second advantage is the asymmetry of the risks involved in holding the position. You are unlikely to lose money but retain the possibility of a significant pay-off should a Eurozone break up occur. Provided you keep faith in the creditworthiness of the federal German government, the greatest risk is a sharp rise in Eurozone inflation, which erodes the value of your principal.

You also risk a mark to market loss should German yields rise from your purchase price, but holding the position to maturity would negate this.

The final advantage to the trade is tactical the position is highly liquid and cash like so there is little opportunity cost in holding it. In the event of more attractive investments arising over the duration of the bond, it can be easily sold and the proceeds reinvested.

Many smart investors have over the years come up with complicated ideas to bet on the break-up of the single currency, with mixed results. It may be that the simplest and most effective has been staring them in the face all along.

The big risk of this embedded option trade is if inflation jumps in the block.

_ Farzan Ghadially