Reasons for Global Bond Volatility
When thinking about increasingly volatile markets, the German bund market would not necessarily be seen as a likely source of volatility. But over the past couple of weeks the implied volatility levels of this market have soared. If you were an investor in a 30-year German bund, capital losses would have amounted to 15% over the past couple of weeks. Yields have risen from around 0.50% in mid-April to 1.15% at the end of last week.
Developments in Europe, where we have also seen an appreciable recovery in the euro versus the US dollar, are driving events elsewhere. Interestingly, US treasury yields have risen across the curve, led by longer-dated maturities, despite ongoing US economic data disappointments. The implied volatility level of US treasuries, as measured by the MOVE Index, has also moved meaningfully higher from 70 to 90 over seven trading days, before settling around the 80 mark.
In our view, the factors contributing to the ‘bond’ rout are twofold: 1) investors are reassessing the deflation tone and seeing some reflation (albeit moderate), which is leading to 2) the unwinding of highly correlated trades, held by investors over the past year.
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Indeed, over the past 12 months, the disinflationary backdrop led investors to implement ‘curve flattening’ trades by holding overweight exposure to long-duration assets. However, at the same time, investors were sanguine in their view that inflation was not going to destroy earnings multiples and so they stayed long equities. Some of those views are now being reassessed and investors are consequently repositioning.
Importantly, though, liquidity constraints, which we believe will be an increasing feature of market performance over the longer term, have exaggerated price moves due to the high correlation of bond and equity market performance. However, unlike most of last year, bond and equity correlations are now starting to trend lower rather than higher.
We expect the recent market volatility is a result of repositioning rather than anything more sinister. Reassuringly, higher yielding credit markets have been relatively stable. We should also remember that the eurozone has a large buyer on the side in the form of the European Central Bank!
Nevertheless, a lot of investors have been feeling the pain in the short term, including some high profile trend-following hedge funds. We have maintained our short duration bond positioning in the UK and US (we hold no exposure to eurozone sovereign debt), which has benefitted year-to-date performance, and we remain neutral in equities, with regional biases in Europe and Japan.