Why the bond market has gotten more nervous

JSOULS MADDISON was sure he had scored. As his free kick broke through the wall of Arsenal players, a goal seemed certain. Somehow Arsenal goalkeeper Aaron Ramsdale got his hands on the ball and held it aside. “Best save I’ve seen in years,” said Peter Schmeichel, a former goalkeeper. Others noted a crucial detail. Before the ball was hit, Mr. Ramsdale was on tiptoe, his weight evenly distributed, ready to jump back and forth. By keeping a perfect balance, he made a miracle stop possible.

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Balance (or lack of it) matters in financial markets, just like in football. A market in which bets point in one direction is vulnerable to large price changes in the other direction. When positions are out of balance traders can be caught off guard by even a small change in sentiment or in the news. Some of the recent volatility in global bond markets can be attributed to biased positioning. When liquidity is uneven, as in today’s treasury market, the results can be surprisingly large changes in bond yields.

To understand all of this, imagine that you are thinking about a trade. You notice that covid-19 infections are on the rise in Europe and governments are imposing partial blockages. Meanwhile, there are signs that the US economy is picking up speed. You conclude that the Federal Reserve will have to raise interest rates sooner than expected and much sooner than the European Central Bank. One way to profit from this analysis could be to sell the euro against the dollar.

Before going ahead, it would be wise to check how other traders are positioned. America’s Commodity Futures Trading Commission publishes regular reports on traders’ positions on currency futures and options. If, say, there were already a lot of euro shorts, you should be feeling less gung-ho. After all, while many traders have already sold the euro, there are fewer potential sellers to lower it in the future. And there are dangers when many investors bet one way. In the event of unexpected and positive news for the euro, speculators who sell the currency would expect losses. Some would be forced to buy back the euros they had sold. As more traders scramble to hedge their short positions, the euro is likely to appreciate strongly. This is a classic “short squeeze” or “washout position”.

This brings us to the volatility of the bond markets. Deducing traders’ positions from bond futures is tricky, says Kit Juckes of Société Générale, a bank. The nature of finance is to borrow for the short term and to lend for the long term. This “natural positioning” will tend to obscure other speculative bets, says Juckes. Perhaps this is why much of the recent talk about volatility has focused on liquidity – how easy it is to enter or exit a position quickly. A report released this month by a task force from the U.S. Treasury, Federal Reserve, and other regulators provides one example. He attributes the dramatic increases in bond yields to evanescent liquidity, for example in March 2020 and February of this year. He attributes this to a change in the structure of the market. New regulations following the global financial crisis of 2007-09 made it more expensive for banks to hold large stocks of bonds to facilitate transactions with customers. A small group of high frequency electronic traders has since supplanted the banks. These companies keep the market super liquid most of the time. But they are poorly capitalized and cannot hold many bonds for long. In volatile markets, they are forced to take less risk. So when liquidity is needed most, it tends to disappear.

These and other changes in the structure of the market have tended to make positions more extreme. Bond buyers are less heterogeneous, says George Papamarkakis of North Asset Management. The funds are bigger. Information travels faster. And momentum trading, buying recent winners and selling recent losers, is a more common feature in bond markets. In the heyday before the financial crisis, there were market makers who were ready and able to lean against momentum, take a fundamentals-based perspective, and hold bonds for more than a year. ‘a day (or a few seconds). But not anymore. The posts therefore become crowded. When a news goes against a popular trade, the leaching can be quite dramatic.

A market that leans too much in one direction is ultimately forced to reverse. In this regard, the bond market is like a goalkeeper betting on the direction of a free kick. He shifts his weight to one side of the goal in anticipation. But he often remains desperate as the ball heads to the other corner.

Learn more about Buttonwood, our financial markets columnist:
Baillie Gifford and the Three Dilemmas of Fund Management (Nov 20, 2021)
Cash is a low-yielding asset but has other virtues (November 13, 2021)
A quantum walk on Wall Street (November 6, 2021)

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This article appeared in the Finance & economics section of the print edition under the title “Full tilt”

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