Last week marked the culmination (so far) of a truly dramatic collapse in developed market bond yields.
The frantic duration grab manifested itself in 10-year US yields diving below 1.50%, 30-year yields pushing below 2% for the first time, ultra futures trading limit-up in extended hours action Wednesday morning and, of course, the 2s10s inverting that same day, much to the chagrin of equities and a frustrated US president.
Although the moves were in part driven by proliferating global growth concerns (exacerbated last Wednesday by lackluster activity data out of China and confirmation that the German economy contracted in the second quarter), collapsing inflation expectations and the assumption of lower rates, we and plenty of others were quick to note that receiving flows/convexity hedging were turbocharging things.
Read more: ‘We Have Not Been Bullish Enough’ Or, Misery Redux
BofA, for instance, cited “duration demand created when we reach new lows in yields, due to the negative convexity portfolio hedgers such as the MBS community”, in explaining why things have escalated so quickly.
Well, on Tuesday, JPMorgan suggested that “fundamentals explain less than half of the move in interest rates and inversion of the yield curve in recent weeks”.
“Mortgage investors and banks are forced to chase a decline in yields, which we believe has rapidly created more than $500bn of demand”, the bank’s Josh Younger said.
When that kind of flow hits amid low liquidity, you have a recipe for outsized moves.
As Younger observes, “the magnitude of convexity hedging YTD was likely the largest of the post-crisis era”. It thus makes sense that yields fell further than can be explained by fundamentals alone.
(JPMorgan)
Meanwhile – and as alluded to in these pages on countless occasions this month – liquidity is sparse. In fact, as Younger goes on to show in a series of additional charts, including a rather stark visual that plots the deterioration in market depth and price impact atop 3M10Y vol., August sticks out like a sore thumb.
Finally, if you’re wondering whether at least some of this is attributable to HFTs pulling back in a high-vol. environment, the answer would appear to be yes.
(JPMorgan)
“Low latency participants have grown to represent a majority of liquidity provision in US rates markets, but their presence is vol-dependent”, JPMorgan’s Munier Salem notes, adding that “HFT trading participants are responsible for an outsized share” of the observed drop in liquidity.
The takeaway: Mind the self-feeding loops and don’t discount the potential for modern market microstructure to serve as gasoline on the fire.
Makes sense. The last steep drop in liquidity shown in the JPM chart coincided with a steep fall in US Treasury yields. When liqudity returned, UST yields continued declining but more slowly.