Investors have learned a big lesson not just once, but twice, this year: once in April and then again in May.
That big lesson was that the bond market is not a one-way bet. Overstretched positioning, lingering fears over deflation, overly pessimistic views on the outlook for eurozone growth and worries around Greece added their weight to the swing in yields. And overlaying all these events was a brand new feature for some fixed-income markets – illiquidity. Inevitably, investors quickly found out that this lack of liquidity is magnifying market movements.
European Central Bank president Mario Draghi commented on the higher levels of volatility in his own inimitable style, stating that market participants should “get used” to it. Whether or not you agree with his sentiment, the ECB would certainly not want to see yields rise too far, too fast. A quick look at the successive periods of quantitative easing in the US, Japan or the UK shows a clear pattern emerging: a rally in bonds, which lowers yields, followed by a subsequent steady rise. This pattern makes intuitive sense to a certain extent: the very reason for undertaking QE programmes in the first place is to stimulate economic growth and inflation, which would then logically be reflected in higher yields.
As the outlook for growth improves and inflation expectations move higher, the ECB should be able to sit back and congratulate itself on its achievements. But there is a caveat: if yields move too fast too early, this could effectively act as unwanted tightening of monetary policy – and that could see those all-important inflation expectations start to fall again. So what does all this mean for the ECB’s credibility? It could take a severe hit, especially if the central bank were forced to ramp up its asset purchase programme in response. Other ECB members have emphasised that they would be prepared to act if “excessive fluctuations” in the market could impede “the achievement of our objective”. In fact, the ECB is already taking tangible steps to address the issue by front-loading the bond purchases to better match with issuance from eurozone governments. So maybe it is a case of “get used” to it, but not too much of it.
It goes without saying that the amount of market liquidity – or lack of it – varies in each specific segment of the fixed-income market. Corporate bond liquidity has been significantly affected by regulatory changes that were designed to prevent a repeat of the events that led to the Great Financial Crisis. Dealer inventories have declined because the Volcker Rule means that market-makers can no longer include proprietary trading. Meanwhile, increases to capital requirement ratios under the Basel III rules mean that banks are not only cutting their exposure to riskier assets, but are holding an increasing amount of ‘safer’ assets to offset any potential losses, thereby effectively drawing more liquidity out from the markets.
The lack of market liquidity does not create the volatility we have seen over the last two months, but only acts to amplify it. While it is difficult to attribute the recent bouts of volatility to any single event, rising inflation expectations based on stronger eurozone growth and a stabilisation in the oil price are the likely culprits. Overstretched positioning and speculation also rank as big contenders. And, of course, hindsight – always a wonderful thing – suggests that the five-basis-point yield on offer on a nine-year German Bund was never really a good sign.
As we come into the summer, the Greek debacle is likely to still be rumbling on, although the crisis changes so fast an outcome may be known by the time this article is published. At the same time, the US Federal Reserve may well be inching towards its first rate hike in over five years, with most market commentators anticipating a September date for lift-off. Taken together, these two uncertain events have the potential to create a perfect storm of volatility late in the summer, and with liquidity thinner than normal, that volatility could make for a very bumpy ride indeed.
Kerry Craig is global market strategist of JP Morgan Asset Management
