Bond market chaos is a dangerous side effect of fighting inflation

(Bloomberg) — In their crusade to rein in runaway inflation, the world’s major central banks risk fueling further chaos in the bond markets that play a crucial role in the economies they are trying to protect.

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Policymakers, in a rush to get consumer prices under control, are rapidly raising interest rates and ending programs that have made them major buyers of government debt in places like the United States, Europe and the United States. Australia. Investors have yet to pick up the slack, which has helped create a liquidity crunch that has led to historic swings in yields over the past few months.

“The worst we’ve ever seen,” is how Andrew Brenner, head of international fixed income at NatAlliance Securities, characterizes bond market conditions. “Central banks have ruined liquidity from what it used to be.”

From Sydney to Frankfurt to New York, market weaknesses long hidden by ultra-loose monetary policies are on display, stoking concerns of potentially painful disruptions that could ripple through other markets and the economy in his outfit. The once boring German Bunds are the biggest jumpers, while Australian bond futures are nearly the most volatile in 11 years. Japanese bankers are grappling with days when no benchmark bonds are trading.

But it’s in the $23 trillion U.S. Treasuries market where the dislocations are causing the most problems, fueling angst among investors and regulators about what can be done to shore up this crucial global financial linchpin.

With US Treasuries serving as a risk-free benchmark for more than $50 trillion in fixed income assets, the extreme volatility of their yields could make it harder for private sector companies to raise capital easily and at cost. as low as possible. Market swings also threaten to bring chaos to what has traditionally been the preferred asset class of pension funds, retirees and others seeking the safest possible investment returns. And all of this could in turn pose risks to the wider economy, which could eventually force central banks to change their plans.

The European Central Bank is already working on a program to limit premia on the lowest-rated government debt in the eurozone. In the U.S., the Federal Reserve’s lack of Treasuries buying has crippled trading – and some dealers even say the turmoil in money markets could pressure the Fed to revise its cutback plans. of its portfolio which had swelled to nearly $9 trillion due to the purchase of bonds as part of quantitative easing.

“We are now seeing outsized intraday yield movements in the US as well as European markets,” said Lawrence Gillum, fixed income strategist at LPL Financial. “If we start to see more cracks in the markets, the Fed will be in a really tough spot as they try to fight inflation on the one hand and support the proper functioning of the Treasury market on the other. “

The legacy of measures to strengthen the banking system following the 2008 global financial crisis is increasingly in focus. Tighter capital rules and restrictions on the use of leverage have made banks less willing to expand their government bond trading capacity, crippling one of the world’s most crucial sources of liquidity. market.

australian angst

That wasn’t much of a problem when central banks were absorbing the billions of dollars in securities that governments were issuing to fund the fight against the economic fallout from the Covid-19 pandemic. But the lack of market making by banks is problematic now that the Fed and many of its counterparts are reducing their debt holdings.

“The size of the market has increased significantly,” said Rob Nicholl, who heads Australia’s Office of Financial Management, which oversees the country’s debt issuance. If the market-making ability doesn’t follow, “when you have periods of volatility, you’re almost mathematically going to have periods where liquidity disappears faster.”

While worries about bond market liquidity have been spreading for years, the fears are unquestionably materializing in 2022. The momentum is showing as intraday yield swings of more than 10 basis points become commonplace across most major markets.

A Bloomberg measure of Treasury liquidity is near its worst level since the spring 2020 trade lockdown at the start of Covid-19. Barclays Plc strategists point to other metrics, including higher transaction costs.

In Europe, German bonds were rocked by the highest volatility on record by some metrics, as investors grapple with both the end of ECB quantitative easing and a deeply rooted rate hike cycle. uncertain, all as trading volumes decline during the summer months.

This means that the performance of a security can be dramatically different between the time an investor makes a trade and moments later.

“It doesn’t matter if it’s levels, spreads or curves, all moves could be outdated within minutes and see appropriate U-turns at any time,” said bond trader Jens-Christian Haeussermann. at Commerzbank AG in Germany. “Cash has decreased significantly.”

The wild nature of US bond trading has unsettled some international investors – a significant group of buyers of US debt.

“What’s been happening recently are moves unrelated to news or events – and that suggests players may be scrambling to cover positions,” said Eiichiro Miura, managing director of the fixed income department at Nissay Asset Management Corp., a unit of Japanese. leading life insurer.

Miura’s domestic market is not immune to liquidity problems, although the problems in Japan center on the amount bought by the Bank of Japan rather than the end of purchases. A legacy of years of massive bond buying by the BoJ – it now owns around half of the government bond market – is that there simply isn’t much supply available to investors.

Japanese bond buyers have had a harder time closing deals since any period outside of the 2008 global credit crisis. There have been bouts of low volume in both the government securities spot market and futures contracts. Sellers failed to deliver 3.53 trillion yen ($26 billion) of government bonds in June, the second-highest amount on record in BOJ data dating back to 2001.

Similar problems are visible in Europe and are about to get worse.

A regulatory measure that will come into force in September will force hundreds of asset managers to post more collateral – at a time when there are fewer high-quality investments available to fulfill this role. Germany’s free float – or the amount of its debt available in the general market – is around record highs, according to Bloomberg Intelligence.

Since risk-free securities are harder to trade, this undermines the environment of the tens of trillions of dollars of assets compared to them – the so-called spread products. Without incentives for big banks to add market-making liquidity, the risk is that the costs will be borne by borrowers and investors in asset markets.

“While sovereign bond markets are still performing very well, policymakers’ appetite for holding risky positions is well below normal,” said James Wilson, senior portfolio manager in Melbourne at Jamieson Coote Bonds, which oversees A$4.3 billion ($3 billion). ). This has been the case “particularly for spreads – leaving markets jittery and prone to the very wide daily ranges we’ve seen lately.”

Despite the volatility, not everyone sees evidence of structural problems in global bond markets. Fed Chairman Jerome Powell told lawmakers in June that the Treasuries market was performing “reasonably well.” However, former Treasury Secretary Timothy Geithner is among those calling for structural reforms to address liquidity issues as the Fed’s market footprint shrinks.

For Kevin McPartland, head of market structure research at Greenwich Associates, it’s unclear if the bond market is “just broke” or if this type of action is simply what we can expect during a particularly volatile period. Either way, the situation invokes the old notion of “moral hazard” – or the risk that aggressive central banker policies could distort market prices and possibly burn investors when reversed.

“It’s hard to pull the punch bowl away,” McPartland said, referring to the withdrawal of accommodative monetary policy. “Everyone has gotten so used to the Fed backstop. It’s hard to tell if the market needs it or just got used to it. I really question the idea of moral hazard.

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