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Curve sketching

Some readers surely still remember curve sketching in mathematics¹. As students we learned how to use mathematical methods to find gradients, inflection points, points of intersection, as well as maxima and minima. Challenging, but not impossible to master.

We also deal with curves in the world of finance although, strictly speaking, they are not curves in the sense of continuous functions but clusters of points, which the viewer connects like dot-to-dot puzzles: yield curves².

Now, there are many theoretical models that try to describe why a yield curve has one particular form rather than another. There’s pure expectation theory, liquidity preference theory and market segmentation theory. Readers who wish to learn more can have a look at the very dry material on Wikipedia³ or, for a more entertaining read, go to the old Market Commentary from October 2017, in which our Chief Economist Yves Longchamp⁴ looks at the various different approaches to the yield curve.

Regular readers of our Market Commentaries will already know that, due to current events, we will once again address the very flat U.S. yield curve. On 27 August 2018, the regional Federal Reserve Bank of San Francisco published a new study about the power of the U.S. yield curve to predict future economic development⁵.

Figure 1: Interest rate differential between 10- and 2-year U.S. sovereign bonds.

The above graph shows the interest rate differential between 10- and 2-year U.S. sovereign bonds as well as the timing of the last three recessions, as published by the National Bureau of Economic Research⁶. It seems that approximately 18 to 24 months after a yield curve inversion – that is, when the long-term interest rate was lower than the short-term interest rate – the U.S. economy slid into recession. “There you have it!”, is no doubt the response from the statisticians among you. Or it could be a spurious correlation, that is, a purely coincidental relationship, not a causal one. One example of this is the quasi-serious study which found that the stork does deliver babies after all⁷; there’s also another collection of amusing spurious correlations⁸.

Joking aside, readers can rest assured that there are a great many very credible studies that try to explain the form of the curve. However, there are many researchers who claim that there is a causal relationship between the distinct flattening of the curve and the U.S. central bank’s quantitative easing. Ultimately, the central bank did greatly distort the market with its bond buying and thus brought about much lower yields, especially at the long end of the yield curve. The authors of the study from the regional Fed in San Francisco, however, conclude that those in the “this time is different” camp lack demonstrable statistical significance for their theory. Consequently, one would then have to assume that although U.S. growth is still regarded as highly robust, there is a considerably higher risk of a future recession in the event of a sustained flattening of the U.S. yield curve. If one still believes, as the author does, that the U.S. economy is very significant for global growth, then the relevance of this scenario for us Europeans as well becomes abundantly clear.

Figure 2: Probability of U.S. recession

Figure 3: Performance of 10-year Bund and Treasury yields

Figure 4: Steepness of the yield curves in the U.S. and Germany

Figure 5: A box trade

The U.S. central bank in New York has also developed a model which it uses to calculate, based on many variables including the form of the yield curve, the probability of the domestic economy slipping into recession. The probability has climbed to 13.6% for July 2019 (see Figure 2). This value is not particularly high plus, in the end, it’s just another model. However, the dynamics of development are striking. 

It is clear from Figure 3 how closely linked the U.S. and European financial markets are. Yields have moved in step for long periods of time over the past 30 years; only in the past couple of years have we seen a certain degree of decoupling between the two markets. Blaming this solely on the ECB’s ongoing quantitative easing is without a doubt somewhat too narrow a view. We believe that the continuing uncertainty about the stability of the euro also has a huge impact on the very low Bund yields. Even after the termination of the ECB’s asset purchase programme (APP), expected at the end of this year, it is possible that long-dated Bund yields will remain low. In fact, the inflation outlook would justify this eventuality. This would be a disaster for German pension schemes, but even more so elsewhere. 

Lastly, we want to take a look at the different slopes of the yield curves on opposite sides of the Atlantic (see Figure 4). The U.S. curve is very flat but the German curve is not as flat as one might expect considering how low the long-term yields are. The fact is that, at 100 basis points, the German curve is at a happy medium in terms of the interest rate differential between 2- and 10-year sovereign bonds. This is mainly due to the harsh fact that the yields on 2-year sovereign bonds are -0.6%. Figure 5 shows the difference between these two degrees of steepness. As is plain to see, the box trade has almost hit a 15-year high. Courageous arbitragers could use this circumstance to enter a Bund flattener against a Treasury steepener. Market momentum argues against this trade but fortune favours the brave! 

But let’s go back to the fact that the Bund curve is relatively steep. Why is this relevant? At present, many market players expect the ECB to raise interest rates no earlier than summer 2019, or at least this was what could be read into the statements made by Central Bank Council members. If the U.S. yield curve turns out to be predictive of the probability of a U.S. recession, then we could possibly see the first clear signs of darkening clouds on the economic horizon in summer 2019: at the exact same time as the ECB’s potential first rate hike in more than 10 years. However, we assume that under such circumstances the ECB would not raise interest rates. Therefore, there is a real possibility, with a probability greater than zero, that we will head into a European recession with negative central bank interest rates. Not a nice prospect but, luckily, not really very likely in our view. 

However, we would not warrant the trust our investors place in us if we ignored the unpleasant possibilities. Once again, to make it perfectly clear: we do not expect a U.S. recession to set in in the next 12 months. Growth is very robust and even seems to be gathering momentum in the third quarter. Globally, however, growth seems to have passed the peak. It remains solid but rates are slowing. As one would say in calculus, the first derivative is positive but the second derivative is already negative.


Positioning of the Ethna Funds


2018 has been all about populism and the financial markets fell very much under its influence in August as well. For example, the new Italian government and its election pledges are causing concern among investors and politicians in the present financial situation; there is a crisis in Turkey, partly as a result of the open confrontation between Erdogan and Trump; the U.S. President is also keeping up his aggressive stance in relation to international trade; then, in consequence, we have the developments in growth in China, which if nothing else are impacting all emerging markets. We mustn’t forget Russia and North Korea either.

  • While in July yields were still rising rapidly, in August a countermovement set in. In Europe, 10-year Bund yields fell from 0.45% to just over 0.30%. It was a similar story with U.S. sovereign bonds – all the more surprising considering the latest inflation figures. We got reaffirmation recently in Jackson Hole that there will be further rate hikes this year. Higher interest rates were also promised in 2019, which is in keeping with economic data.
  • Equity markets on opposite sides of the Atlantic posted contrasting performances. Europe continues to be hit by outflows, which are standing in the way of a significant rise in prices even though valuations can already be described as cheap. For example, the DAX again lost almost 4% in August, due  to share price falls for Bayer and Continental, among others. Meanwhile, the S&P 500 climbed about 2.9% and the Nasdaq-100 was even up a further 6%. At present, the equity market equivalent of Bunds and U.S. sovereign bonds – regarded as the safe havens of the bond market – are U.S. equities, which, though not very cheap, are rightly enjoying investor confidence.
  • As in March, there was a significant general widening of risk premia for corporate bonds in August as well, much more so for cash bonds than for synthetic securitisations which, similar to March/April, did not work perfectly. This meant that in August the Ethna-DEFENSIV lost 0.12%. 
  • Duration in the Ethna-DEFENSIV was increased slightly in August to its current level of 3.3. The next Fed rate hike in September really shouldn’t come as a surprise to anyone. But the outlook for 2019 will keep investors in suspense in the coming months. Market expectations, which range from zero to four more rate rises, could not be more different. The expectations for Europe are unchanged. The turnaround in interest rates should come no sooner than summer 2019, though the new Italian government and the resulting widening of the risk premium is likely to cause massive headaches for the ECB in Frankfurt.
  • The average rating within the Ethna-DEFENSIV remains A+/AA-. The sector breakdown, too, remained virtually unchanged in August. We have only recently begun to open equity positions in the Ethna-DEFENSIV once again. We believe that the unpopular bull market in equities is likely to bring about even higher prices. The allocation is just above 2% at the moment.
  • On the currency front, we made a profit on our slightly long position in CHF. We believe that the risk of an intervention by the Swiss central bank will rise substantially the closer we get to the CHF 1.12 mark against the euro.


August again clearly demonstrated that not only is the time of synchronised economic growth over for now but so, too, is the time of synchronised market fluctuations. While in the U.S. equity indices – on the back of an extraordinarily good reporting season and virtually unaffected by the crises in the rest of the world – climbed to new all-time highs, the prices in Europe and, above all, in emerging markets again went into correction mode over the course of August. In addition to the escalating trade conflict between the U.S. and the People’s Republic of China, the markets were shaken up by the crises in Turkey and Argentina, which culminated in a massive depreciation of the respective currencies. The ensuing market reaction – falling yields on safe-haven sovereign bonds and a stronger U.S. dollar – was a logical consequence in this risk-off environment. The risk of a strengthening U.S. dollar having a critical effect on the solvency of some emerging markets has not gone away, but is not as immediate, not least due to a return to the levels seen at the beginning of August. These developments had only a moderate effect on long-term interest rates in the U.S. and Europe. Recent confidence did bring about a slight rise in yields; however, at approximately 33 basis points for 10-year Bunds and 2.86 % for their U.S. equivalents, interest rates are still low. The situation in Italy, on the other hand, remains tense. Here, yields at the long end have recently risen to 3.2 %.

  • The focused yet conservative fund positioning has proven successful in this environment. We are still of the opinion that the equity markets in the U.S. and China hold the most potential. Nonetheless, we took advantage of the last week in August to take profits on our position in the American market. The rationale for this was that valuations are once again quite challenging, as well as the risk of an intensification of the trade war. Therefore, the Ethna-AKTIV’s equity allocation temporarily dropped from 25% to 20%.  Subject to an improvement in the situation, we are prepared to increase the equity allocation to up to 30% once again on an opportunistic basis.  In addition, we firmly believe that the preparation of the Italian budget, which is set to be announced in September, will put Italy on a collision course with the EU. This will bring about further increases in credit spreads on Italian sovereign bonds. Our short position in Italian securities now stands at 8.4% (nominal) and is currently contributing approx. 20 basis points to fund performance. Now that we can easily imagine an interest rate above 4% in Italy, we will expand the position in the next few days to 10%, as planned. Furthermore, on the currency front, we have expanded the USD position to 6.5% and are holding on to our CHF position of 5%. In addition, we have begun to build up a position in the pound sterling with rates around 1.10 (GBP/EUR).
  • Over the month, the S&P gained approximately 2.9%, which boosted the performance of the Ethna-AKTIV.  Furthermore, bond portfolio performance was up again in August, benefiting from the recent decline in risk premia and falling yields. The performance of the Ethna-AKTIV is up approximately 1% since its low in July, although our strong emphasis on risk positions in China and Italy made no more than a limited contribution to performance in the past two months.  Given the events of recent weeks, we believe our very focused positioning is still appropriate and we are confident that it will be a strong positive contributor to fund performance in the coming months.


Why go down the easy route when there’s a hard one? We must ask ourselves this question in light of the high weighting of European equities in the Ethna-DYNAMISCH. Almost all European equity markets closed the month down, while their U.S. counterparts were up. Although our European securities did also make a positive contribution to the overall result thanks to active stock selection, the overall regional headwind is considerable and there is no sign of it dying down for any length of time. The conditions have been the same for quite some time now: due to greater political and economic uncertainties as well as weaker growth, valuations in Europe are much lower than in the U.S. However, for the premium one pays, U.S. companies are offering more attractive fundamentals. Looking at developments in recent weeks, the list of potential risks is not getting any shorter and, more importantly, 9 times out of 10 the potential impacts will hit Europe harder than the U.S. Within the Ethna-DYNAMISCH, therefore, we made the following portfolio adjustments in August:

  • Equity exposure remained almost unchanged overall and, at 60%, equities are still the clear investment focus of the fund.  Due to the fall in European equity indices, we made a profit with the hedging components in this segment, locking in these gains. We shifted the maturity of renewed hedges from September to December. We also extended the put option hedges on the U.S. market to December. Conversely, opportunistic portfolio hedging specifically for the U.S. technology sector was reduced, meaning that the net equity exposure including derivatives now stands at 52%. 
  • We made much more extensive adjustments in individual stocks within the portfolio. For example, we closed a few positions which could end up being value traps in the long run; that is, they are in danger of remaining cheap for the foreseeable future. These include the media group RTL, the lighting products manufacturer Signify (formerly Philips Lighting) and the South Korean vehicle manufacturer Kia. We have also drastically reduced all our European financial positions, since we are of the opinion that there will be no interest rate rises in Europe for the time being.
  • The list of purchases included expansions in various existing positions, as well as the German chemical company BASF, the Japanese specialist in automation products SMC and the U.S. multi-technology conglomerate 3M, known mainly among retail customers for its glues. All three companies are out-and-out technology leaders in their fields and we were able to buy them on attractive terms after recent dips in their share prices. On the whole, the transactions have distinctly improved the quality of the companies in our portfolio. Both the improvement in quality and the successive shift from Europe to the U.S. is likely to keep us busy over the next few months as well.
  • Bonds and gold are having virtually no effect on the performance of the Ethna-DYNAMISCH at present due to their low weighting. Considering the recent fluctuations in these segments, we can be glad of our cash position, which was increased in a countermove. On the currency front, while we did see much stronger price movements, these levelled off over the month. Because the exposure to foreign currencies is relatively low for a fund that invests globally, the price volatility of the Ethna-DYNAMISCH was correspondingly moderate.

Looking ahead, the risks and opportunities for the equity markets are balanced. With our active allocation, the value-oriented selection approach and the intelligent hedging components, the Ethna-DYNAMISCH remains well-positioned to deal with the uncertain market environment. At the same time, the portfolio’s asymmetry means it has every opportunity to participate in rising equity markets and individual investment ideas.

Figure 6: Portfolio ratings for Ethna-DEFENSIV

Figure 7: Portfolio composition of Ethna-DEFENSIV by currency

Figure 8: Portfolio structure* of Ethna-AKTIV

Figure 9: Portfolio composition of Ethna-AKTIV by currency

Figure 10: Portfolio structure* of Ethna-DYNAMISCH

Figure 11: Portfolio composition of Ethna-DYNAMISCH by currency

Figure 12: Portfolio composition of Ethna-DEFENSIV by country

Figure 13: Portfolio composition of Ethna-AKTIV by country

Figure 14: Portfolio composition of Ethna-DYNAMISCH by country

Figure 15: Portfolio composition of Ethna-DEFENSIV by issuer sector

Figure 16: Portfolio composition of Ethna-AKTIV by issuer sector

Figure 17: Portfolio composition of Ethna-DYNAMISCH by issuer sector


* “Cash” comprises term deposits, call money and current accounts/other accounts. “Equities net” comprises direct investments and exposure resulting from equity derivatives.

The investment funds described in this publication are Luxembourg investment funds (fonds commun de placement) that have been established for an unlimited period in accordance with Part I of the Luxembourg Law of 17 December 2010 relating to undertakings for collective investment (the “Law of 17 December 2010”). An investment in investment funds, as with all securities and comparable financial assets, carries the risk of capital or currency losses. The price of fund units and income levels will therefore fluctuate and cannot be guaranteed. The costs associated with fund investment affects the actual performance. Units should solely be purchased on the basis of the statutory sales documentation (Key Investor Information, sales prospectuses and annual reports), which can be obtained free of charge on the website or from the fund management company ETHENEA Independent Investors S.A., 16 rue Gabriel Lippmann, L-5365 Munsbach. All information published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information or a solicitation of an offer to buy or sell securities. Contents have been carefully researched, compiled and checked. No guarantee for correctness, completeness or accuracy can be provided. All information published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information, or an offer to buy or sell securities. The contents have been carefully researched, compiled and checked. No guarantee can be given for correctness, completeness or accuracy. The information includes past data which are no indicator of future performance. The management fee, custodian bank fee and all other additional costs are taken into account in the calculation of the unit price as stated in the provisions of the contract. Performance is calculated using the BVI method (German federal association for investment and asset management), which means that the calculations do not include an issuing charge, transaction costs (such as order fees and brokerage fees), custodian bank fees, or other management fees. Including the issuing surcharge would reduce performance. The performance shown is not a reliable indicator of future performance. Munsbach, 30/11/2018