When bond markets become silly
Investors are understandably spooked by recent bond market ructions given a backdrop of weakening growth in major economies, and continued accommodative central bank policy. One analyst argued on Monday that this “tantrum” was partly technical, but also the result of markets looking through to higher inflation expectations due to an apparently better economic outlook. Markets are being driven by leveraged players liquidating positions, but disagree about the root cause. Here’s why. As a starting point, we have argued since late last year that bond markets had become significantly overvalued. Our advice was to stick to US fixed income, but to shorten the duration from 30 years to 7 years and to move out from corporate bonds towards treasuries. Today, the overarching point is that the arrival of Europe’s quantitative easing (QE) sparked silly behaviour, and recent moves are partially correcting the excesses that have built up.
The arrival of the ECB’s counterproductive QE convinced some market players that they were being offered a free ride. Hence, they hopped aboard by going massively long on the German and Italian bond markets. Such was the flood of money into bunds and BTPs that the 6-month rate of change for their 30-year yields reached a six sigma overbought position. Being smart, these investors are also likely to have gone short on the euro and, of course, substantial leverage was almost certainly in play. In sympathy, US bond yields declined to a three sigma overbought position. Such episodes of extreme silliness seldom last for long and are being unwound in both the bond markets and the US dollar.
The broader message is that markets can become awfully unstable as a result of central bank actions to try and manage asset prices. The argument made a few weeks ago was that the effort of central banks to suppress volatility was creating a dangerous feedback loop such that in the case of US equities, the collapse in the CBOE Volatility index caused banks’ value at risk models to increase the leverage that their clients can “reasonably” take.
These ructions have been driven entirely by the impact of momentum and automatic risk controls of the type just described. To be clear, such price moves contain zero economic information about future growth or inflation. What they do confirm is that in central banking land the inmates have truly taken over the asylum. In time, as this great free money experiment starts to unwind, we are sure to see far more severe volatility outbursts in the prices of all “managed” assets.