Thursday, 15 September 2016

Bonds may be choppy but it's no repeat of Bund 'flash crash'

European bond yields are rising as investors entertain the possibility that the post-2008 era of super-charged central bank stimulus could soon end, but a re-run of last year's German bond 'flash crash' should be avoided.

The shakeout has been triggered by growing unease about a possible U.S. interest rate hike this month, news that the Bank of Japan is studying ways to steepen the bond yield curve and disappointment at the lack of action at last week's European Central Bank meeting.

Additional fuel to the selling fire came in the shape of a Deutsche Bank report last week that said the end of the bond market's 35-year bull run could be within sight.

Because yields are so low and even negative, it doesn't take much of spike to cause outsized price falls and such volatility. This is exacerbated by extremely poor liquidity, which makes it difficult for investors to trade and get out of positions.

Half of the $54 trillion universe of government, asset-backed and corporate bonds as captured by the Barclays Multiverse Global Bond Index is held by central banks and commercial banks. They tends to hold their positions for months or years.

And the wider fallout this time has been greater, with stock market volatility higher than it was in April last year. Sudden spikes in bond yields after long periods of apparent calm make it trickier to accurately price other markets, such as stocks.

But while the move up in yields is the biggest since June, a repeat of last year's Bund 'flash crash', which saw yields explode nearly 100 basis points to 1 percent, is unlikely.

Market positioning isn't as extreme today, demand from yield-starved investors will limit how high yields rise and, while expensive, Bunds aren't as overvalued relative to other countries' bonds as they were 18 months ago.

"We're not as vulnerable as we were in March/April 2015. Probably, the worst is behind us rather than in front of us in terms of the rates selloff," said Nikolaos Panigirtzoglou, strategist at JP Morgan in London.

"With (the ECB deposit) rate stuck at -0.4 percent for the foreseeable future there are many bond investors desperate to take advantage of any yield rise in the euro area. So there's firepower to keep yields low and reverse any big increase," he said.

Germany's 10-year Bund yield rose to 0.06 percent on Monday, its highest since Britain's vote on June 23 to leave the European Union and up from -0.12 percent last week. It had been below zero every day since the Brexit vote.


The jump in yields wrong-footed markets, precipitating a worldwide slide in stocks, bonds, commodities and the dollar's value against the Japanese yen. U.S. stock market volatility, the so-called VIX 'fear index', is higher now than it was at any time during the Bund 'flash crash' turmoil last year.

Between April and June last year the yield on 10-year German sovereign bonds surged to 1 percent from just above zero.

But this time round, JP Morgan's Panigirtzoglou notes that while euro zone bond investors mandated to buy only euro-denominated assets are loaded up on bonds to a similar degree, multi-currency funds are nowhere near as extended.

That means the scope for forced selling is greatly reduced.

"Positioning this time isn't really a factor. It's much more neutral, and if anything, investors are underweight duration," said Ciaran O'Hagan, senior rates strategist at Societe Generale in Paris.

"I don't expect this (sell-off) to go too far, certainly not a repeat of last year, precisely because positioning isn't as aggressive. Bond yields can rise without the bond bubble bursting. We're looking for a moderate sell-off," he said.

Valuations aren't quite as stretched either. In March last year, the 10-year yield differential between Bunds and U.S. Treasuries was 190 basis points, a euro-era record. Now the spread is around 165 basis points.

Similarly, using five-year/five-year forward swap rates as a measure, euro zone and U.S. bonds are much more closely valued now than they were early last year just before the Bund's 'flash crash', notes JP Morgan's Panigirtzoglou.

Much will depend on the U.S. Federal Reserve and when - if - it raises interest rates. Financial markets still expect that to be December, even though some Fed officials have suggested it could be later this month.

Because market pricing is moving towards December, a move then wouldn't be a shock. September, however, would be a surprise, and likely force a repricing across markets that would push yields sharply higher.

In June last year, Fed officials played down rate hike expectations, and only delivered one quarter-point increase in December. It remains the only U.S. rate hike since June 2006.

Even if the Fed does raise again this year, the prospect of persistently slow growth and low inflation will probably ensure that the tightening cycle is gradual, limiting the scope for a prolonged bond market sell-off.

Reference: Jamie McGeever

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