Time out ! What exactly is going on in these chaotic bond markets, and what is an "air pocket" ?

Wednesday 13th May 2015

 

Time out ! What exactly is going on in these chaotic bond markets, and what is an "air pocket" ?

 

"Share prices tumble as spooked investors succumb to great bond market sell-off" , The Times, p.44

  and

"QE speculators come to their senses as growth improves in Eurozone" , The Times, p.45

  and

"Turmoil amid government bond chaos" , The Daily Telegraph, p.B1

 

If you are fortunate enough to be able to take the time to stand back and get clear in your head what's behind the recent crazy moves in bond markets, i.e. you haven't suffered a 15% capital loss in two weeks for example, now might be a good time to do it. Given the importance of these markets, and their knock-on effect for equities and almost everything else, it must be a worthwhile exercise even if it means revisiting some regular themes.

In general terms, global bond prices have soared (and therefore yields have plummeted) since Q3 2014. The last few weeks however have seen a massive reversal in these moves. The yield on the 10yr German Bund for example has risen from a low of 0.07% to nearly 0.7%. The fundamentals behind it all ? In short, improved prospects for European growth and the rally in oil prices, if not exactly signalling strong inflationary pressure, do at least remove the fear of deflation. Fair enough, and perfectly sound reasons for causing a market correction  --  but why such a "super-correction"?

We have to take into account how the market was positioned. Investors with a need to put their money into "safe-haven" vehicles such as government securities were happy to buy bonds with minimal or even negative yields in the expectation of being able to flip them into the ECB's QE (bond buying programme) for a profit. They should have listened more closely to ECB boss Mario Draghi back in April when he said that the ECB would not buy bonds at ANY price, and that the programme was flexible enough to be adjusted. Those purchases now look less like a "safe bet", and more like a plain old "bad trade"  --  hence the rush to get out.

Which brings us back to market liquidity (yes, again!) . Near-zero interest rates and QE programmes have greatly increased what might be called "money liquidity". At the same time, banking regulation and its capital constraints have greatly reduced the number of market makers and proprietary traders in the market-place, and therefore its "trading liquidity". It's a toxic combination. Any wave of orders in one direction (as is often the case in these days of computer-generated trading signals) can no longer be absorbed by the players that until recently fulfilled that role. Instead, it is met by a vacuum that greatly exaggerates market moves.  This condition has come to be known as an air pocket (phew, we got there in the end). They may not be as physically debilitating as the variety experienced in flight, but can make you feel an awful lot sicker.

Many senior traders feel the problem of the lack of market liquidity is here to stay. No apologies therefore for harping on about the subject  --  we're going to have to get used to it.