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When markets are in turmoil, traders turn to their favourite hedges.
They’re going for a classic form of protection against recession — buying short-dated German bonds versus interest-rate swaps — that would pay off if things get worse from here. The premium between the two hit its widest level in over a year Friday.
There was a similar dynamic seen during the French election in 2017, when a victory for the far-right Marine Le Pen looked possible, and during Italy’s budget dispute in 2018.
This time it’s the coronavirus that’s reaping the damage, curbing international transport, closing factories and disrupting supply chains. Stocks have been hammered, and yields of high-grade bonds have been plummeting to fresh lows as investors protect themselves against a deep economic slowdown.
“Risk-off dynamics are intensifying once more as markets have to handle the negative corona newsflow by themselves with the ECB remaining silent and the next Fed meeting still ages away as measured in current currency,” wrote Commerzbank AG strategists Michael Leister and Marco Stoeckle in a note to clients. “With ECB-inaction to leave spreads vulnerable we reiterate our tactical longs in 2y Schatz ASW-spreads to position for ongoing risk-off.”
The gap between the German two-year yield and interest-rate swaps widened to touch 47 basis points Friday, the highest level since Dec. 2018. While the short-tenor bonds benefit from being haven assets, the swaps carry credit risk.
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