Bill Gross’ German bund short could spell disaster

The trade that George Soros and Stanley Druckenmiller pulled off in 1992 by betting against the British pound — and making $1 billion in the process — has gained legendary status. So when Bill Gross, the world’s best-known bond investor, tweeted on Tuesday from his current employer Janus Capital that betting against German government debt is the trade of a "lifetime," he reached for that bit of history to benchmark the current opportunity. Overlooking the fact that he got the year wrong (we all make mistakes, right?), here’s how the numbers would play out if he’s correct:

The bet that the UK couldn’t keep propping up its currency at an artificially overvalued level was Druckenmiller’s idea; Soros’s contribution was to persuade him that if he was convinced about its potential, he should bet the farm on it. Sure enough, in the middle of September 1992 the UK abandoned its efforts to keep the pound trading in a corridor around a central target of 2.95 deutsche marks. At the point of capitulation, the pound was trading at 2.81 marks; in the space of three weeks, sterling had dropped by 14 per cent, and was worth just 2.41 marks.

The 10-year German bund currently trades at a price of about 104, for a yield of 0.09 per cent. For it to replicate the performance of the pound all those years ago, the price would have to drop to 89.4 by May 13. At that price level, the yield would shoot up to almost 1.7 per cent, causing a tsunami of repricing across trillions of dollars of government debt around the world.

If 10-year German debt was suddenly yielding 1.7 per cent, Spanish bonds (currently at 1.4 per cent) or Italian debt (1.42 per cent) and even US Treasuries (1.9 per cent) would see the biggest jump in yields ever. Government and corporate borrowing costs everywhere would surge as investors reassessed the value of fixed-income securities in light of the German move; the knock-on effects into other asset classes would be catastrophic as yields rose, bond prices fell and investors backfilled their losses in a wave of selling and margin calls.

It does seem intuitively uncomfortable to be lending money to the German government for a decade in return for less than one-tenth of one percent (and indeed to be paying for the privilege of lending for any time period shorter than nine years). So Gross may well be right. If he is, investors will find themselves in the midst of a financial Armageddon that could make the Great Crash of 1929 look like a walk in the park.