An experienced trader was telling me the other day that he has never seen market volatility like he is seeing this year. Given that he is talking on the basis of 20+ years in the markets, that means he has been through the crash of 2008-09 and even the massive shake-out surrounding the collapse of Long-Term Capital Management in 1998. He may even have been bloodied in the bond market collapse of 1994, which was considered a very big deal at the time.
Of course, given the propensity of traders to hype things up, he might be exaggerating. But he isn’t. There is overwhelming evidence, not just anecdotal chat, to confirm that volatility is indeed far stronger than anything that might be considered normal. This is true for currencies and, above all, for the government bond market.
As this column has said many times over the years, the bond market is far more important to national and global economies than is the equity market. Given the global property mania underway in recent years, it is more than sufficient to say that the entire real-estate sector – especially the commercial market, but ultimately the residential one as well – is merely a derivative product of the yields offered on the bond market, to highlight its overriding role.
Unfortunately, the bond market looks to be in big trouble.
The primary evidence for this is not the fact that prices of government bonds in key countries such as the US, UK, Germany and elsewhere have fallen in recent days.
The problem is the speed and extent of that fall, which follows a rapid rise earlier this year. Both the rise and the fall are telling the same story, which is that liquidity in these markets has become scarce.
But government bond markets are supposed to be the deepest among the world’s securities markets, with “deepness” serving as a metaphor indicating they have lots of liquidity, lots of buyers and sellers, and hence they offer “depth” to investors, meaning the ability to buy and sell, enter and exit the market, on a large scale and with ease.
Conversely, a lack of liquidity – a shallow market – means tat large deals, whether buying or selling, find few takers on the other side and therefore have a large impact on the price. This was the case when the bond market was going up – buyers were overwhelming sellers, because there were so few of the latter. Now the markets have turned and large-scale sellers are finding that the buyers have disappeared and the price needs to fall a long way for their offers to generate sufficient buying interest to absorb them.
The same pattern is at work in the currency markets, despite the fact that these are larger and hence more liquid even than the bond markets. Or, at least, they used to be. But now the currency markets are swinging sharply on a minute-to-minute, hour-to-hour and day-to-day basis.
Back to the bond market The force driving up the bond market last year and into this one was the policy of key central banks to conduct “quantitative easing,” which meant in practice that they bought their own countries’ bonds. The scale on which this was done was so large that the central banks quickly became the biggest “investors” in the sovereign bond sector – and that other investors, notably pension funds and other institutions, were pushed out of this market and forced to invest more of their savers’ money in other, less solid asset classes – including corporate bonds, emerging market sovereign debt and equities.
This policy has dire long-term consequences for savers, but in the short term it simply pushed bond prices through the roof and their yields through the floor – the zero floor, meaning that the bonds ceased to offer a positive yield and reached prices where their yield to maturity was negative. Investors in these bonds were “guaranteed” that, if they held them to redemption, they would get back less money than they had put in, two, five or 10 years earlier.
In April, an estimated one-third of the total amount of sovereign debt issued by developed countries was offering negative returns. At this point, several luminaries of the American investment scene finally spoke up, saying that the emperor had no clothes. This blinding insight caused the market to slow and then stop its upward rush.
Lo and behold, the cry of “Fire!” in a market crowded entirely on one side sparked a mad rush for the exits – and the sellers found that the exits were blocked, i.e. there were no buyers at the absurd price levels reached.
That was when, why and how the price falls began.
Exhibit A: The German government 10-year bond was offering 0.04 percent yield, but is now back to a yield of over 0.6% per annum – not much, but less mad. Exhibit B: US 10-year Treasury bonds have jumped from a yield of 1.6% to 2.2%, – and these examples are of yields that never actually passed the zero mark, which shorter term bonds did, on a large scale.
The investors who bought at the top of the market have already suffered heavy losses, especially if their purchases were leveraged by using borrowed money. But that is a relatively minor issue. The real problem is that the market dynamics have changed and prices may continue to fall, as more such speculative buyers are flushed out. That would create a “waterfall” effect, where each price fall triggers more selling.
Were this to happen, the impact would soon be felt in other markets and then a full-scale meltdown could ensue.
Of course, this is just a doomsday scenario and nothing to really worry about. After all, nothing like it has happened since, let’s see – oh yes, 2007.