Panic sets in on bond volatility
This week’s bond rout has traders panicking and investors making frantic calls to their advisers as the “ultra-profitable” trade in European bonds has come to a screeching halt.
The rout seemingly caught investors off guard. Many in the market expected that as bond yields began their rise in April, traders would see bargains and come back to support prices (prices and yields move inversely to each other).
But the support never came, especially in Europe, where the crash in prices has been swift and shocking following months of negative yields. German bund prices this week saw their biggest two-day drop since 1988, based on data from Citigroup.
“There is a repricing going on and it is very significant,” said Edward Jong, vicepresident and head of fixed income for Tri-Delta Financial in Toronto.
Jong said the end of Europe’s massive bond market rally began in earnest on April 29, when some of the biggest bond investors in the world started betting against the market. That should have alerted investors that influential market players were no longer willing to stomach record high prices and having to pay governments for the privilege of lending them money.
Norway’s $900 billion sovereign wealth fund announced on April 29 that it would exit longterm euro bonds in its $328 billion bond fund.
It had already toned down its European bond exposure from 60 per cent to 40 per cent of its portfolio in October. Meanwhile, bond guru Bill Gross and Jeffrey Gundlach of Doubleline Capital both jumped into the anti-Europe trade as well, setting off a huge spike in yields for much of the next month.
While bond prices recovered Thursday, the trading day was again marked by extreme volatility. The German 10-year bund spiked to 0.99 per cent in the morning, its highest level since September, before reversing and ending at 0.84 per cent. The Bank of America Merrill Lynch Global Broad Market Index, which tracks the global bond market, has now erased all its gains for 2015 and is back at the same level it was sitting at in December.
The sudden capitulation in bonds spooked stock markets as well on Thursday. The S & P 500 fell 18.23 points, or 0.86 per cent, to 2,095.84. The S & P/TSX Composite Index fell 135.29 points, or 0.89 per cent, to 15,019.39. Equities also fell in Europe, with the Stoxx Europe 600 down 0.8 per cent.
The steepest drop in the bond market came Wednesday, after European Central Bank president Mario Draghi said during a news conference that the bond market should “get used” to volatility. Traders had hoped that after two months of whipsaw trading, Draghi would offer reassurances about the need to keep bond prices steady.
Mark Chandler, head of fixed income and currency at RBC Capital Markets, said the bond market has now repriced itself to a more reasonable level, returning to where prices were at the end of 2014. He added there could still be further pain as traders accept that Europe’s once profitable bond trade could now be over.
“What we’re seeing is a repricing of the ultralow interest rates to where they should be,” Jong of Tri-Delta said. “The new normal is going to be price discovery — figuring out where bond yields are actually supposed to be, because at zero or even negative yields is obviously not right as the market has realized.”
He said that bonds are just beginning to price in a U.S. Federal Reserve interest rate hike later this year. Analysts polled by Bloomberg on average expect a 25-basis point rate bump from the bank by September.
The sharp volatility of the past month has also highlighted what has been a lack of liquidity in the bond market, making any repricing sharp, sudden and painful for the market. Regulatory changes in the wake of the financial crisis have limited the role of banks as dealers in the market, removing a significant cushion of volatility.
While demand for bonds has made buying them less of an issue, finding buyers in the market when investors look to sell has been behind much of the panic in the market. “Even in large, liquid markets, volatility is way up,” said Chandler. “There is some fear, as well, that the bond market has not been fully tested, which could happen when the Fed hikes rates.”
The Fed has tried to smooth volatility by telegraphing its monetary policy in a clear way to investors, but even with that approach, Jong notes investors could still panic. The taper tantrum of 2013, which followed months of hints that quantitative easing was ending, is an example of how even telegraphed policy is not always enough.
Jong does think, however, that the pain ends when the 10-year U.S. Treasury goes to 2.75 per cent. On Thursday, the 10-year note was trading at 2.33 per cent, a slight recovery from the 2.4 per cent it hit in morning trading — the highest level since October.