The ECB is buying around €60bn of bonds each month as part of its QE programme. This had two big effects: 1) it led to a shortage of bonds that were suitable for the ECB to buy; and 2) it gave a ‘green light’ to hedge funds to borrow money for little cost, buy bonds and sell them to the ECB. The unprecedented rally in euro bonds that drove German 10y bonds to a low of 0.055% (5.5bps) was a ‘crowded’, ‘one-way’ trade and like all good one-way trades it’s great until it isn’t. The historic liquidity provided by central banks created the illusion that markets are liquid but has also created complacency about the ability to liquidate portfolios when required.
This was first raised late last year by the governor of the Bank of England, Mark Carney, who noted that it was taking up to 7 times longer to liquidate a bond portfolio that it did before the GFC. Investment banks that used to run large proprietary trading positions have been prohibited by regulators from doing so, thus reducing a valuable buffer of liquidity in times of market shock. The bond ’flash crash’ that occurred in October last year and caused US 10y bonds to rise an unprecedented 30bps in an hour before reversing again was the first real sign that even the highly liquid US Treasury market was vulnerable to such shocks.
There have been several other warning signs of markets experiencing large ‘gaps’ in traded prices when a large number of traders are seeking to exit a trade. Which brings us back to euro bonds. Large numbers of traders piled into euro bonds thinking that the ECB would provide buying support for the market when they wanted to exit. They were wrong. Add a combination of poor data, nervousness over Greece exiting the euro and good old-fashioned panic and you have the extraordinary situation of German 10y bonds being sold from around 5.5bps to as high as 80bps. This huge pricing dislocation did not occur in isolation and bonds around the world saw yields rise sharply, including in Australia.
As we close the month of May, German bonds have tracked back down to 0.49% with many sovereign bonds following suit downwards. The events have heightened the worry that the liquidity provided by central banks is somewhat of an illusion and liquidity in real debt markets has in fact gotten worse. And of course this spills over into equity and related markets. It is certainly a case of buyer beware and buying assets that you are prepared to hold.