Bond market volatility has increased in lockstep with uncertainties about the Omicron variant and the likely course of central bank monetary policy to combat inflation.
Less noticed, liquidity has deteriorated even in the world’s most actively traded bond market. It will now be difficult for investors who are long and wrong on rates to average out without a great deal of pain.
Heading into December, Bank of America’s MOVE index of US Treasury volatility was at highs not seen since the omnicrash on lockdowns in April 2020. The bank’s financial advisers were reporting private client holdings of debt down to 17.1% of total assets under management from 25% at the start of the pandemic and a peak of 34% in 2009.
Loss of liquidity has bedevilled bond markets since the great financial crisis and the imposition of proper capital and leverage ratios on banks
Even before year-end, in mid-November rates volatility was making it difficult to price new issues even of below investment-grade, high-coupon instruments.
With commodities offering a 57% annualized return, US treasuries were on track to hand owners a 3.7% loss, with the 30-year down 7.6%. UK government bonds were losing 7%, German government bonds were down 9.6% and Japanese government bonds showed a negative 10.3% return.
It’s not just private clients reducing bond holdings. All the talk is of big, levered macro hedge funds, now quite unable to judge the future course of interest rates, closing out largely one-way directional bets and testing the capacity of bank dealer balance sheets to take them on.
Less eye-catching, because it is such an imprecise measure, the Bloomberg US Treasury liquidity index, which tracks spread variations between bonds with close maturity dates, doubled from early September to late November. That means the spreads between similar maturity treasuries widened. They narrow when markets are liquid.
It’s an early and dramatic response to the rates shock expected in 2022.
Ever-present worry
Loss of liquidity – the ability to buy and sell in size at tight spreads and without moving the market price – has bedevilled bond markets since the great financial crisis and the imposition of proper capital and leverage ratios on banks. As bond markets grew larger and dealer balance sheets shrank, solutions to the ever-present worry of price-gapping in discontinuous markets appeared regularly.
These included all-to-all trading, with the giant asset managers making prices to each other instead of taking them from the banks; and then ETF create and redeem technology to fold illiquid bonds into portfolios with on-the-runs.
But it’s always the same with liquidity: it’s there when you don’t need it in regular markets; it evaporates immediately they get volatile.
Year-end effects come into play. Asset owners aren’t going to provide liquidity to competitors when they just want to close out the 12 months and protect whatever scraps they have picked up from new issue premiums. Seeking to work the positions taken on from macro hedge funds, bank dealers don’t want to show prices that will bring new risk from other customers. Bonuses are on the line.
To take just one anecdote, Shane O’Neill, head of interest trade trading for Validus Risk Management, which handles hedging for alternative managers with $2 trillion of AuM, reports a large European bank declining a request to quote on a routine euro interest rate structure – a liquid and well-banked market in normal times – citing market upheaval and inability to price it accurately.
In the sterling interest-rate swaps market, daily notional traded between banks has fallen on the worst days to tens of millions from hundreds of millions normally.
Finance ministries, central banks, asset owners and intermediaries must keep working on the fraying government bond infrastructure from which all other capital markets hang.
