Savage sell-offs in Bunds, Treasuries, Gilts — and spilling into equities. Are financial markets being engulfed by doom? Is it time to lock down, cut risk and stock up on painkillers and bandages?
There’s no need to panic yet. The volatility of the past three weeks — most clearly seen in the dramatic reversal of the 10 year Bund yield, from 0.05% on April 17 to 0.7% on May 7 — strongly recalls another recent jarring period in the markets.
That was in mid-October 2014, when, in a flash crash for the bond market, the 10 year Treasury yield plummeted from 2.2% to 1.85%, then rose back to 2.15% within a day.
The violence of that move caused consternation and confusion. But as one leading bond investor put it then, it was “just a good, old-fashioned, momentum-driven puke of positions”.
This week, the same investor used exactly the same words to describe what has happened in bond markets in the past fortnight.
Two U-turns
In October, investors had been bearish on bonds, and suddenly lost conviction. This time, the reverse has happened. Investors have been madly long, especially in Europe — and have now got the willies. So, does the parallel stand up?
As 2014 began, investors had just been told, a week before Christmas, that the Fed would begin tapering quantitative easing. Surely, with the Fed scaling back its buying, Treasury yields were due to rise?
All the smart investors positioned themselves for that, with short duration — ready to profit when the curve inevitably steepened. Except it didn’t.
The 10 year Treasury yield, which had begun the year at 3%, just kept on grinding lower, as the US economy signally failed to reach escape velocity, dragged down by a sluggish Europe and a wobbly China.
Then in October, after an IMF meeting in Washington full of gloomy speeches, the investors capitulated. Short duration trades were reversed — and the quickest way to do that is to buy 10 and 30 year Treasuries.
The ultrafast bond rally of October 15 was reversed in hours, but the drive downwards in US yields soon resumed — in fact, the 10 year yield did not bottom until the end of January, at 1.6%.
October’s sudden loss of faith in economic recovery was marked in the equity markets by a steep V-shaped sell-off and recovery, noticeable across the world. It made a hash of many companies’ plans to raise equity capital in the autumn.
No reason, but it had to come
Like October’s sudden sell-off, the fast moves since late April this year, centred this time on the Bund market, have no obvious trigger in any fundamental economic event.
Last time, the spark was said to have been a poor US retail sales figure; this time, the flimsy suggestion that worries about wage pressure in the US were to blame has been advanced.
More convincing to some investors is that positions had simply got stretched to breaking point.
In the first part of this year, the herd was obsessed with the European Central Bank’s launch of QE. Much longed-for and heralded they rejoiced over when it arrived.
As another investor put it, “the market has been very focused on flows” — above all, that the ECB was buying everything. “Now,” he added, “fundamentals are trumping flows, which is always the case”.
By mid-April, even the nine year Bund had been pushed into a negative yield, and the 10 year looked about to follow.
But the conviction that this bizarre situation could go on forever became fragile. Long duration, curve flattening trades began to look like losers. Once the bond balloon was pricked, it popped loudly.
A rise in rates can trigger sell-offs of other, riskier assets like credit and equities. So far, that has been limited. Credit investors and bankers are still calm, and bankers say emerging markets have not been hit yet, although it may only be a matter of time.
But on Tuesday, the stock markets did take a pounding, with the Euro Stoxx 50 down 1.4% and the bond sell-off widely blamed.
Central bank vs economy
Like in October, the recent Bund gyrations can be seen as a weight of investors, which had been betting technically with the ECB suddenly facing up to the fact that the economy was pushing bonds in the other direction.
In this case, however, the economic signal is one of encouragement, rather than disappointment.
There are glimmerings of hope for Europe’s economy, and investors will not have forgotten that during US QE, Treasury rates, counterintuitively, rose, apparently because the market priced in the idea that QE would work.
Unless the future looks blacker than black, a negative 10 year Bund yield just doesn’t seem to make sense.
That should mean the rout in bonds does not have to be accompanied by a crisis in equities.
Credit still has a firm tone, investors say, and there are no major risks on the horizon in developed markets, where companies are cash rich and have fat margins.
Government bonds, however, could remain a rollercoaster ride for months. One experienced investor said there was very little point trying to guess which way the next 10bp-15bp move would go.
Most of the investors who felt most exposed and were likely to sell bonds purely because of recent price action have probably done so by now. That’s one guess. Equally, there are investors who have been long duration for many months, are still in the money on the trade, and may be looking for another chance to sell out.
Ultimately, the ECB has the Bund market’s back — it is set to buy many times the net German issuance in the coming months.
Whether the right level for the Bund yield is 0.05%, minus 0.2%, or 1% is anyone’s guess — but sharp moves like those of the last weeks are at least a sign that flatlining is not the only way for Europe, and that queasy consensus trades can get violently cleaned out from time to time.
If you’re in risk assets, take heart — but if your mate is a govvy trader, get some Paracetamol in, just in case.