When bond mar­kets be­come silly

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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