Why the bond market has become jumpier

Why the bond market has become jumpier

yamis madson He was sure he scored. When his free kick hit the Arsenal players’ wall, the goal looked certain. Somehow Arsenal goalkeeper, Aaron Ramsdale, got the ball and put it away. “The best save I’ve seen in years,” said former goalkeeper Peter Schmeichel. Others pointed out the important details. Before the ball could be hit, Mr. Ramsdale was on his toes, his weight evenly distributed, and ready to jump in either direction. By keeping his balance perfectly, he made the miracle rescue possible.

Balance (or lack thereof) is important in financial markets, as in football. A market where bets are tilted in one direction is subject to large price swings in the opposite direction. When positions are out of balance, traders can be mistaken even with a slight change in sentiment or in the news. Some of the recent volatility in global bond markets can be traced back to skewed positioning. When liquidity is patchy, as in today’s Treasury market, the results can be some surprisingly large shifts in bond yields.

To understand all this, imagine that you are thinking of a deal. I notice that COVID-19 infections are on the rise in Europe and that governments are imposing partial lockdown. In the meantime, there are signs that the US economy is regaining momentum. It concludes that the Fed will have to raise interest rates sooner than people expect, and much sooner than the European Central Bank. One way to profit from this analysis might be to sell the euro against the dollar.

Before moving forward, it would be wise to check the status of other traders. The US Commodity Futures Trading Commission publishes regular reports on the positions of traders in currency futures and options. If, for example, there were already a lot of euro shorts, you should feel less excited. After all, if many traders are already selling the euro, there are fewer potential sellers to push it lower in the future. And there are risks when too many investors bet in one direction. In the event of unexpected positive news for the EUR, speculators who lack the currency will recoup losses. Some will have to buy back the Euros they sold. With more traders scrambling to cover their short positions, the Euro will rise sharply. This is the classic ‘short press’ or ‘position whitening’.

This brings us to the volatility of the bond market. Deducing traders’ positions from bond futures contracts is difficult, says Kit Juckes of Société Générale. The nature of financing is short borrowing and long lending. Jokes says this “normal positioning” will tend to obscure other speculative bets. This is probably why so many recent discussions of volatility have focused on liquidity – how easy it is to get in or out of a position quickly. This month’s report by a working group drawn from the US Treasury, the Federal Reserve and other regulators provides an example. She blames sluggish liquidity for huge jumps in bond yields, for example, in March 2020 and February of this year. He attributes this to the change in market structure. New regulations in the wake of the global financial crisis of 2007-2009 made it more expensive for banks to maintain large stocks of bonds to facilitate customers’ trading. Banks have since been replaced by a small group of high-frequency electronic merchants. These companies maintain superior liquidity in the market most of the time. But it has little capital, and it cannot hold many bonds for long. In volatile markets, they are forced to take on less risk. So when liquidity is sorely needed, it tends to fade.

These and other changes in market structure tend to make situations more extreme. George Papamarkakis of North Asset Management says bond buyers are less diverse. Funds are bigger. Information flows more quickly. And momentum trading, buying new winners and selling new losers, is a more prevalent feature of bond markets. In the days before the financial crisis, there were market makers who were willing and able to build on momentum, take a view based on fundamentals, and hold bonds for more than a day (or a few seconds). But not anymore. So the positions become crowded. When a piece of news goes against a popular trade, the fade can be very exciting.

A market that tilts away in one direction eventually has to reverse. In this respect, the bond market is like a goalkeeper gambling where the free kick goes. Moves its weight to one side of the target in anticipation. But he is often left fluttering in desperation as the ball heads toward the other corner.

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This article appeared in the Finance and Economics section of the print edition under the heading “Full tilt”


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