Bonds: anatomy of a market meltdown

Financial Times – Legend has it that a young man once asked the financier J Pierpont Morgan what the stock market was going to do. “It will fluctuate,” Mr Pierpont is said to have replied. Had the young man asked Mr Pierpont about the US Treasury market – where the US government sells trillions of dollars worth of bonds to a wide range of investors – he may have received a very different response. For decades, the US Treasury market has been a bedrock of global finance. While stock markets are prone to sudden price swings, such episodes in the vast and easily-transacted world of Treasuries have been far rarer – giving the market an exceptional reputation for orderly trading. That reputation took a big hit last month.

On October 15, the yield on the benchmark 10-year US government bond, which moves inversely to price, plunged 33 basis points to 1.86 per cent before rising to settle at 2.13 per cent. While that may not seem like much, analysts say the move was seven standard deviations away from its intraday norm – meaning it might be expected to occur once every 1.6bn years. For several minutes, Wall Street stood still as traders watched their screens in disbelief. Electronic pricing machines, which now play a bigger role than ever in the trading of Treasuries, were halted and orders cancelled by nervous dealers as prices see-sawed.
The events have sparked a financial “whodunnit” as investors, traders and regulators seek to understand what happened – and to determine whether October 15 was a unique event or a harbinger of further perilous trading conditions to come.

“We’re all looking for a chief reason because clients want to understand the impetus behind market volatility,” says Reggie Brown, head of exchange-traded fund trading at Cantor Fitzgerald.
Among US regulators’ concerns is whether a tougher regulatory climate for big banks, coupled with the inexorable rise of electronic trading, has fundamentally altered how the $12.4tn government bond market functions. The answer has profound consequences for the conduct of Federal Reserve policy and how the US funds its national debt.
For the Fed, the resilience of the Treasury market will be a consideration as it begins to raise interest rates. Analysts say the risk of a highly volatile market reaction suggests the central bank will move in measured steps when it begins to raise borrowing costs, which many expect to begin next year.
One worry is that the US Treasury market might have suffered a pronounced loss of support for prices – or “liquidity” in financial parlance – due to changes that have swept over Wall Street including the rise of computer-driven trading. Some draw parallels with the “flash crash” that hit stock markets in May 2010, which eventually spurred efforts to reform the wider equity market.

James Angel, associate professor at Georgetown University, says the US Treasury market should be regulated in a different way now that it has embraced electronic trading. “When people use computers to provide prices across markets it [liquidity] can be withdrawn in a heartbeat,” he says. “How much market liquidity really exists under this type of market structure and what changes should be made are the questions for regulators.”
Unlike other bond markets, US Treasuries are viewed as being open for business for the entire global trading day. They also enjoy safe-haven status during times of tension. The immense size of the market means investors can easily express opposing views about the direction of interest rates by buying or selling the government debt. Any indication that the market can suddenly shut down with little warning raises troubling questions about how the nature of trading has changed in recent years. Electronic systems are more visible to the whole market, so trades tend to be smaller than those that take place in private telephone conversations between dealers and investors.
A recent gathering of US Treasury officials and key representatives of dealers and investors, known as the Treasury Borrowing Advisory Committee, held in a Washington hotel, revealed “a wide variety of views regarding the potential drivers of the intraday volatility” on October 15. Members of the TBAC include JPMorgan Chase, RBS, Morgan Stanley, BlackRock, Pimco, Citadel, Brevan Howard and other major players in the Treasury market.

A number of US regulatory agencies are looking at last month’s Treasury market mayhem. An official at the Federal Reserve Bank of New York told the Financial Times: “In the course of our normal market monitoring we regularly explore and assess market developments.” Timothy Massad, chairman of the US Commodity Futures Trading Commission, which regulates interest rate futures trading at the Chicago Mercantile Exchange, said that the agency’s initial view was that the market had functioned reasonably well given the high number of trades.
“Let me just add, that’s based on our preliminary look. New evidence might come to our attention that suggests otherwise.”
When dawn broke on a grey October 15 in New York, traders and investors had plenty of reasons to be nervous. Concerns over the spread of Ebola and weakening economic activity in Europe and China were weighing heavily – helping to push bond yields lower as investors sought the refuge of US Treasuries.
The scuppering of AbbVie’s £32bn deal to acquire Shire left many big hedge funds nursing heavy equity losses and may have contributed to the rapid repositioning that would eventually engulf markets.

When US retail sales for September flashed across news screens at 8:30am and confirmed the first monthly decline since January, concern mounted among investors that the US economy could well be softening. For investors who had positioned themselves for a strengthening economy that would propel the Fed to raise interest rates before 2017, it was a painful reversal of sentiment. Many had placed record bets on interest rates moving higher via futures contracts listed on the CME.
With many hedge funds and money managers already suffering a poor year, their offside wagers on interest rates and other failing trades now required emergency action. What subsequently unfolded, according to traders, was a series of massive positions being liquidated and dumped on to the market.
One hedge fund manager recalls being bewildered by subsequent events: “What on earth was charging through the market to want volume at such a price and why, in response to that catalyst, did the electronic marketplace just take any and all liquidity away?”

By 8:45am, liquidity began noticeably deteriorating, and the process accelerated after 9:30am, according to data from Nanex, a market research firm. By 9:33am, the yield on the 10-year Treasury had sliced through the critical 2 per cent level, causing many who had bet on rising yields finally to capitulate and close out their negative bets by buying back US government debt and various interest rate futures contracts.
In September, hedge funds had established a record net “short” position in interest rate futures according to CFTC weekly data. Between the end of September and the week ending October 21, this big bet shrunk from 1.27m contracts to just 217,000, reflecting more than $1tn of notional exposure being cut.
“The elephant tried to squeeze through the keyhole,” says John Brady, managing director at RJ O’Brien, a futures broker in Chicago.

Eric Hunsader, Nanex chief executive, says the scale of the shift in US Treasury prices may have prompted the “market-makers” who usually support trading of the debt to retreat: “The speed of the move was abnormal and trading systems lack historical data for such episodes that can provide them with some guidance.”
When the day drew to a close nearly $1tn worth of cash Treasuries had changed hands, illustrating the intensity of the rush for the exit. Such huge volumes also show liquidity was available, but was possibly difficult to obtain at prices deemed reasonable by investors on the day and amid rapidly fluctuating markets. The head of trading at a major dealer-bank says: “Once volatility shows up, you don’t want to make a mistake in a fast market and so you always see dealers pull back from providing prices.”

Compounding such pressures are changes that have transformed Wall Street since the financial crisis, with the big banks who once dominated Treasury trading now under tougher balance sheet constraints thanks to regulation and a newfound aversion to risk.
This trend has encouraged greater electronic trading and a migration of experienced traders from dealers to hedge funds and asset managers, leaving a younger generation of traders manning Treasury desks at big banks. Many of these have never experienced the gung-ho pre-crisis days when banks were more willing to make bets on the market.

“The appetite to take on a position is lower than it was pre-new regulation,” says Greg Gurevich, managing partner at Maritime Capital Partners, adding that compensation structures “do not reward the trader to take risk that may ultimately cost the trader his or her job”.
The two main electronic trading venues for US Treasuries are run by Nasdaq’s eSpeed and Icap’s BrokerTec. In recent years these platforms have opened up to a range of broker-dealers and high-frequency traders. These firms do not underwrite US Treasury debt sales and are often viewed as opportunistic – providing prices when they spot a quick profit and then retreating when trading turns tricky. Customer orders are now transacted and almost instantaneously hedged, or offset, by computer systems – a type of automation that works well when trading is orderly but rapidly breaks down when the situation changes. At such moments, turning off the machines becomes a necessity. This contributed to the downdraft in liquidity on
October 15.

Dealer-banks don’t really position in bonds,” said one head trader at a large US bank. “They basically act as a pass-through to places like BrokerTec and eSpeed or match off their client flow. The market-makers in this new market are not obligated to be there when everyone’s selling.”
For regulators who have moulded the post-financial crisis landscape and purposefully set out to de-risk the banking system, last month’s turmoil could well show the consequences of their reforms. The worry is that even the highly dependable US Treasury market may now suffer from sudden droughts in liquidity*.
“If the Street – for balance sheet, risk appetite and regulatory reasons – can’t provide a speed bump between buyers and sellers such as hedge funds and asset managers, then the Treasury market will experience a lot more jumps in trading,” says one trader.

As the market becomes increasingly driven by electronic trading, more rules may be required to help deal with sudden violent swings, similar to the adoption of circuit breakers in stock markets. Prof Angel says: “The Treasury market is a freewheeling world where trading is not formalised like that of an exchange and where the use of circuit breakers can help steady activity.” These kind of curbs matter for markets that increasingly trade electronically and also influence other financial areas, such as derivatives and futures.

A broader consequence of last month’s turmoil may be that Fed rate rises will be more likely to take the form of a series of slow steps, rather than big moves that run the risk of sparking turmoil in the bond markets, according to analysts.
For the US Treasury, which is responsible for making sure budget deficits and maturing debt are refinanced smoothly, further episodes of turmoil could well impair the market’s ability to underwrite government debt efficiently, says Michael Cloherty, analyst at RBC Capital Markets.
Mr Cloherty says the US Treasury market has altered structurally and lacks the depth to absorb easily surprises in Fed policy and changes in market sentiment. This trend has gathered pace as the central bank has become a major owner of Treasury debt through its emergency bond-buying programme, further limiting liquidity.
He adds that any sign that the Treasury market’s liquidity has declined would cast a shadow over investor confidence – and may ultimately raise the cost of selling government debt. Says Mr Cloherty: “Investors know they can trade large amounts of Treasuries and any erosion of confidence in the market’s liquidity has long-term consequences.”

Tracy Alloway and Michael MacKenzie
Financial Times
17th November 2014

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