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Why the bond market has become more volatile

November 27, 2021

JAMES MADDISON was sure he had hit. When his free kick went over the Arsenal players’ wall, a goal seemed certain. Somehow, Arsenal goalkeeper Aaron Ramsdale got his hand on the ball and kept it out. “The best save I’ve seen in years,” said Peter Schmeichel, a former goalkeeper. Others noted a crucial detail. Before the ball was struck, Mr. Ramsdale was on tiptoe, weight evenly distributed, ready to leap in either direction. By being perfectly balanced, it enabled miraculous salvation.

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Balance (or lack of it) is just as important in financial markets as it is in football. A market where betting is tilted in one direction is susceptible to large price fluctuations in the opposite direction. In crooked positions, a tiny change in sentiment or news can leave traders on the wrong foot. Some of the recent volatility in global bond markets is due to distorted positioning. When liquidity is patchy, as is the case in today’s treasury market, it can lead to surprisingly large shifts in bond yields.

To understand all of this, imagine you are thinking about a trade. They note that Covid-19 infections are increasing in Europe and governments are imposing partial bans. There are now signs that America’s economy is picking up speed. They conclude that the Federal Reserve needs to hike rates sooner than people expect and much sooner than the European Central Bank. One way to benefit from this analysis could be to sell the euro against the dollar.

Before proceeding any further, it is a good idea to review how other traders are positioned. America’s Commodity Futures Trading Commission publishes regular reports on traders’ positions in currency futures and options. If there has been, say, a lot of euro shorts already, you should feel less excited. Because if many dealers have already sold the euro, there will be fewer potential sellers in the future who could drive it down. And there are dangers with many investors betting in one direction. In the event of unexpected positive news for the euro, speculators shorting the currency would take losses. Some would be forced to buy back the euros they had sold. As more and more traders tried to cover their short positions, the euro would appreciate strongly. This is a classic “short squeeze” or “position washout”.

That brings us to the volatility of the bond markets. Inferring traders’ positions from bond futures is difficult, says Kit Juckes of Société Générale, a bank. The nature of funding is to borrow short and lend long. This “natural positioning” will tend to obscure other speculative bets, says Mr. Juckes. Perhaps this is why the current discussion about volatility has often focused on liquidity – how easy it is to get in or out of a position quickly. An example for this month is a report from a working group made up of the Treasury Department, the Federal Reserve, and other regulatory agencies. She blames the dwindling liquidity for the dramatic jumps in bond yields in March 2020 and February of this year, for example. This is attributed to a changed market structure. New regulations after the 2007-09 global financial crisis made it more expensive for banks to hold large holdings of bonds to facilitate customer trading. A small group of high-frequency electronic traders has now ousted the banks. These companies keep the market super liquid most of the time. But they are thinly capitalized and cannot hold many bonds for long. In volatile markets, they are forced to take fewer risks. So when liquidity is needed most, it tends to go away.

These and other changes in the structure of the market have tended to make the positions more extreme. Bond buyers are less heterogeneous, says George Papamarkakis of North Asset Management. The means are bigger. Information flows faster. And momentum trading, buying from recent winners and selling from recent losers, is a more common feature of the bond markets. In the happy days leading up to the financial crisis, there were market makers willing and able to counter the momentum, take a fundamental view, and hold bonds for more than a day (or a few seconds). But not anymore. So positions become overcrowded. When news goes against a popular trade, it can be quite dramatic.

A market that leans too far in one direction will eventually be forced to turn back. In that regard, the bond market is like a goalkeeper betting where a free kick will lead. With anticipation, he shifts his weight to one side of the goal. But he is often left in despair when the ball heads into the other corner.

Read more from Buttonwood, our columnist on financial markets:
Baillie Gifford and the three dilemmas of fund management (11/20/2021)
Cash Is A Low Yielding Asset But Has Other Virtues (Nov 13, 2021)
A Quantum Walk Down Wall Street (November 6, 2021)

For more expert analysis of the biggest business, business and market stories, sign up for Money Talks, our weekly newsletter.

This article appeared in the Finance & Economics section of the print edition under the heading “Full Tilt”

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