Why the danger of wild swings in the bond markets is here to stay ......

Friday 17th April 2015

 

Why the danger of wild swings in the bond markets is here to stay ......

 "How flash crashes can kick off debate and encourage prudence" , The Financial Times, p.30

 

First, a recap of recent history ......

Back in September 2013, the then Fed Chairman Ben Bernanke quite reasonably attempted to clarify comments he had made in the previous May about scaling back, or tapering off, the Fed's Q/E (bond buying) programme when conditions were right. The market had reacted badly to the May comments, and now completely over-reacted with a huge sell-off in bond markets (and hike in yields). The moves are known as the "Taper Tantrums", and of course have now been more than reversed.

 On October 15 2014, bonds yields dropped a massive 35 basis points in minutes, before returning to their starting level before the end of the day. No fundamental cause for the move was identified, and it is thought to have been initiated by one single large order. This is known as the "Flash Crash".

 
Both events reveal a worrying (terrifying?) lack of liquidity in the system, a condition that produces huge increases in volatility and wildly exaggerated price movements. Why the lack of liquidity ? The new regulatory regime and the capital requirements it has imposed means that there are far fewer market-makers on the street, far fewer houses prepared to hold large positions  --  the market has lost a key shock-absorber. If you also consider the dangers of too many investors holding the same positions and the nature of modern automated trading that cuts out middlemen, the potential for sudden sharp moves is plain to see.

 Ralph Atkins suggests that a few flash crashes might not be such a bad thing if it encourages more prudence among market participants. As he points out, traders scarred by the October 15 experience may not agree. Certainly, although the timing is unclear not much will change before the Fed begins its rate-raising cycle, when some are predicting a "Super Taper Tantrum". But the markets have had enough warning, surely ? Well, they had plenty of warning in 2013 and didn't make a very good fist of it then.

Foundation level further reading on bond trading