‘They Just Kept Coming’: VaR Event Rocks Rates

Although it wasn’t obvious to anyone for whom equity benchmarks are all that matters, Friday brought plenty of fireworks.

PMIs suggesting private sector business activity contracted this month both in the US and Europe, amplified big moves in rates, particularly at the German front-end, where yields plunged ~25bps, the largest move in at least 14 years (figure below).

10-year German yields likewise dropped sharply, retreating below 1% for the first time in nearly two months.

For whatever it’s worth, two-year German yields were below 50bps, where the ECB’s depo rate would be assuming the bank followed up on this week’s upsized rate hike with another large increment in September.

On Thursday, Christine Lagarde said the front-loading implied by July’s move rendered the ECB’s previous guidance for the September gathering void. Indeed, the July policy statement made it clear that virtually all forward guidance is suspended until further notice.

Markets aggressively trimmed ECB bets. Following Thursday’s policy meeting, traders saw 135bps from Lagarde by year-end. As of Friday, they expected just 106bps.

“They just keep coming for USTs and bunds,” Nomura’s Charlie McElligott said, before describing a “full-tilt VaR event spasm” in bonds, where a short squeeze morphed into the establishment of outright longs, eventually catalyzing a “violently unstable” panic trade.

The drama in bunds knocked into US rates. “The PMI measures triggered another leg of the rally in the Treasury market this morning,” BMO’s Ian Lyngen remarked, adding that “the overnight bid was triggered by disappointing European PMIs, so it follows intuitively that this latest move will have traction as the global recession narrative gains further momentum.”

10-year US yields were below 2.75% at one juncture and five-year yields were down 30bps in ~24 hours (figure above).

The past two sessions saw multiple block trades. OI data from CME showed big gains in five- and 10-year note futures, suggesting new longs were established into Thursday’s rally. The standout was a 40,000 five-year note buyer ($1.9m/DV01), but there were other notables.

The bottom line, McElligott wrote, is that there’s “huge new risk being deployed in USTs, likely as longs.” He also noted that considering how consensus the inflation zeitgeist and attendant rates/duration short was, the “return of ‘bonds as your hedge’ spells further looming pain and reversal for all things trend and momentum.” That, in turn, suggests scope for more fireworks, assuming additional forced covering from trend followers.

Around noon Friday, things appeared to calm down, likely on profit-taking in longs and some anticipatory trading ahead of next week’s supply calendar, which is impacted by the Fed meeting. The market will need to digest more than $90 billion between twos and fives ahead of the Fed. Yields at the front-end were richer by as much as 18bps at one point Friday, before fading the move.

“The timing of the two-year auction just two days before a 75bps Fed hike will make the sponsorship that emerges for the most sensitive coupon to monetary policy especially telling,” BMO’s Lyngen said, on the way to delivering a bit of characteristically incisive context: “The sponsorship that emerges for twos and fives takes on an especially relevant character following Largarde’s comments over the past week that larger hikes now do not necessitate a higher terminal later, comparatively more bearish for twos than fives, and the belly’s outperformance following the ECB is very much in keeping with this idea.”