9 June 2015

Bond markets have been beset by big market moves over the past few weeks. In this post, I’ll look at what’s behind the recent volatility and why I expect it to continue.

In the first couple of weeks of April 2015, Germany’s benchmark 10-year government bond (bund) yield looked dangerously close to falling below zero. Then in mid-April, bond yields started suddenly rising – and fast. On 10 April, yields on bunds dropped to just 0.16%. By 11 May, bund yields were up 41 basis points to 0.57%. Over the same period, the yield on UK gilts moved from 1.55% to above 2%.1

The severity of such a sharp sell-off brought into focus the build-up in consensus positioning there has been in fixed income over recent months – and how ill-equipped (in terms of trading liquidity) bond markets are to cope when sentiment suddenly reverses.

So what was behind the reversal in thinking that that led to the sell-off? Well, I believe there were three big assumptions investors were making, particularly about Europe, that became challenged:

Assumption 1: Deflation had arrived

At beginning of 2015, inflation expectations had been depressed, particularly Europe. An unexpected bounce in the oil price in April reduced the prospect of outright deflation and those inflation expectations were raised. Suddenly, holding negative- or extremely low-yielding bonds made even less sense.

Assumption 2: US and UK economies would continue to outperform

The US and UK were supposed to be tightening monetary policy sooner-rather-than later as their respective economies strengthened. A slew of weaker US and UK Q1 data, alongside European data that surprised on the upside, challenged such thinking and investors became nervous.

Assumption 3: The European Central Bank (ECB) wouldn’t have enough bonds to buy

As yields fell across Europe, it looked like there simply wouldn’t be enough bonds available to buy as part of the ECB’s massive quantitative easing (QE) programme (the ECB had said it would buy bonds from two to 30 years in length as long as the yield was above its deposit rate of -0.2%). However, in an attempt to take advantage of lower borrowing costs, a number of governments ‘front-loaded’ bond issuance and the expected shortage of bonds didn’t materialise. Net issuance of eurozone government bonds turned positive in May.

As it became clear these widely-held assumptions were somewhat unfounded, everybody headed for the exit door at the same time, the market couldn’t handle it and bond prices capitulated.

Reversing the reversal

Then on 19 May, European bond prices rallied across the board. The yield on the bund abruptly fell around 10 basis points. Why? Because Benoît Coeuré, an ECB board member, gave a speech indicating that the ECB would respond to the bond issuance calendar by front-loading their purchase programme. Coeuré claimed such a move was not in response to the volatility, but something that had been planned to respond to ‘seasonal patterns in fixed income activity’. However, it looks likely that a summer issuance-lull could still turn net eurozone government bond issuance negative in July.

Riding it out

The recent spikes in bond market volatility highlight that there are two really key factors at play in fixed income, neither of which are likely to change any time soon and that mean volatility is here to stay in the near-term:

  1. Central bankers are the major players in markets and investors hang off their every word.
  2. Illiquidity in bond markets exacerbates bouts of volatility.

So what precautions can investors take to brace themselves? Well, it’s important to remember that active managers view volatility as a good thing – it creates opportunity. However, whether an active manager’s objective is to beat a benchmark or they are more unconstrained in their strategy, I believe today’s market conditions mean it’s critical that they are flexible, by which I mean they are empowered to use derivatives, for instance, and can utilise the widest possible opportunity set to build a portfolio that protects against sudden market moves before they happen.

1 Bloomberg, 21 May 2015

CARS ref: RSM-1094
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 28 May 2015 and may change as subsequent conditions vary.

Everybody headed for the exit door at the same time, the market couldn’t handle it and bond prices capitulated.