It wasn't supposed to be this way. Bond markets, especially government bond markets, were supposed to be safe-haven, boring assets which rarely made headlines. But things have changed dramatically.
On October 15th last year, the yield on the benchmark 10-year US government bonds, saw trading patterns that should only happen once every 1.6 billion years, according to some estimates. The yield plunged by 33 basis points before rebounding by 27 basis points in a single day – enough to acquire the somewhat overused term of “flash crash”.
Beneath the financial headlines, something fundamental has changed and policymakers are sitting up and taking notice. The clear message is that some financial markets are not as fluid as they used to be – or as investors would like them to be.
Fewer people
Simply put, in bond markets, traded volumes are down because there are fewer people willing to trade or provide liquidity than there were five years ago. This has been driven by many banks looking to move out of activities such as capital markets and trading desks as they seek to “de-risk” their business model.
For others the impact and costs of new, tougher regulations make this activity unattractive. The migration of experienced traders from dealers to hedge funds means there are fewer market participants willing to stand in the middle and make a market, and act as “shock absorbers”.
It is estimated that since the crisis, banks have cut the amount of inventory – bonds that could be available to trade – by 70 per cent. This is at the same time as global bond markets have doubled in size. We have also seen a halving in the size of the average block traded in the past 10 years.
The New York Federal Reserve recently gave another example of how slight this inventory position had become when it estimated that dealers’ positions in the credit market stood at $61 billion (€50.8bn). This might seem large but, to put it in context, the holding of just the top five investor groups was 138 times that number.
Mark Carney, governor of the Bank of England, is very concerned about the new market circumstances. In a recent speech, he noted that it now takes seven times longer for an investor to fully sell out of a reasonably sized bond portfolio than it did in 2008.
This is significant when practically all funds that invest in government and investment grade bonds offer daily liquidity to their investors.
The immediate consequence is that volatility in bond markets, including government bond markets has risen. For US treasuries today, volatility is close to twice the level it was 12 months ago. The longer-term consequence is that we can’t be sure how the market will react if faced with significant selling pressure.
We are at a critical point for bond markets. While, in the euro zone, they will dance to the tune of Mario Draghi’s anticipated policy moves, the US and UK are on the path to higher interest rates and, if consensus forecasts are correct, weaker bond markets.
Unappealing cocktail
For bond investors the combination of poorer liquidity, higher volatility and selling pressure may not be an appealing cocktail. And, in the highly connected and correlated world of financial markets, where spill-over and contagion are watchwords, this has implications for investors across all asset classes.
It has implications for central banks as well as they seek to exit from the current emergency status into more normal economic conditions. They will be keen to conduct their interest rate policy in a manner that does not “spook” the markets.
Communication will continue to be a priority and, as we saw with the Federal Reserve recently, language will be chosen to show how "patient" central banks will be. The feedback loop from the financial system to the real economy is well established by now. Eugene Kiernan is head of investment strategy at Appian Asset Management. The views expressed do not constitute investment advice.
