Lower trading liquidity has resulted in "air pockets" causing prices in debt markets to swing wildly for another day
Debt traders suffered another turbulent day of trading on Tuesday, as a global rout in government bonds extended, which some analysts warned might merely be a sign of worse to come.
The prices of government bonds fell across the developed world, including a major German bond sell-off labelled as "large and vicious" by Goldman Sachs analysts.
The yields on 10-year German government notes - which move in the opposite direction to their price - rose by more than 20pc, settling 11pc higher as the day drew to a close.
US Treasuries also rocked back and forth as yields on the bonds climbed by as much as 3.7pc before falling back down to earth, retracing their movements and sliding 2pc below where they began.
Volatility in the bond markets manifested in other markets, driving down the FTSE by 1.3pc and knocking the US S&P500 to the tune of 0.4pc.
The recent sell-off has lacked a single catalyst. Rather, analysts suggested that the correction reflected stretched valuations in the debt markets as investors have struggled to reposition themselves due to thin supply.
Jim Reid, a strategist at Deutsche Bank, said: “It’s not really obvious what caused the sell-off. Everyone seems to have different theories.” Low levels of liquidity have exacerbated the present movements, resulting in larger jumps back and forth as markets seek the correct prices for bonds.
Analysts at Bank of America Merrill Lynch (BAML) said: “The cumulative result of so much central bank support is that the market’s emotional gap between fear and greed has narrowed.”
“This has ultimately given rise to more erratic price swings,” the US bank’s staff said. As investors have attempted to reposition themselves to take account of higher oil prices - a sign that deflation may have been defeated - lower liquidity has made it difficult to make trades.
Financial regulations introduced since the crisis have required banks to hold more bonds, as quantitative easing schemes have meant central banks hold many on their own balance sheets, reducing the number available to trade on the open market.
Simultaneously, central banks have attempted to boost so-called “high money liquidity” with quantitative easing schemes and their close to zero interest rates. “What has become increasingly clear over the last couple of years is that the combination of high money liquidity and low trading liquidity creates air pockets,” said Mr Reid.
He continued: “It’s a worry that these events are occurring in relatively upbeat markets. I can't helping thinking that when the next downturn hits the lack of liquidity in various markets is going to be chaotic. These increasingly regular liquidity issues we're seeing might be a mild dress rehearsal.”
David Absolon, an investment director at Heartwood Investment Management, said that the “recent market volatility is a result of repositioning rather than anything more sinister”. He pointed out that the yields on riskier high yielding credit had remained “relatively stable”.
“Nevertheless, a lot of investors have been feeling the pain in the short term, including some high profile trend-following hedge funds,” Mr Absolon said. Holders of the 30-year German bund have faced capital losses of 15pc over the past couple of weeks, he said.
Tradeweb data showed that more than a quarter of all euro-denominated sovereign debt traded with a negative yield last Friday, far lower than the near 36pc that did less than a month earlier on April 13.
The rise in yields has been good news for Mario Draghi, President of the European Central Bank (ECB), creating more room for the central bank to continue its bond buying programme. The ECB has pledged to buy up €60bn of assets a month, the majority of which are government bonds, until September 2016 or when inflation appears on a path back to its target.
Analysts have cautioned that the size of the debt market the ECB can buy assets in has been small, and made smaller still as more of the yields on the available pool have turned negative. The ECB has committed to not buying bonds yielding less than its deposit rate, which is currently set at minus 0.2pc. (The Telegraph)