Could Global Bond Markets Be Broken?

Getty/Stephen Dunn

While most focus has been on whether US stocks are overvalued, another key question in global markets at the moment is whether the lack of physical trade (low volume) in US bond markets and elsewhere is a signal the system is becoming more unstable.

After the initial bond sell off in the second half of 2013, which saw US 10 year interest rates move higher from around 1.5% in April to around 3% in early 2014, finished and rates began to fall again there was hope that the taper would be a non event. Indeed the recent rally in US bonds reinforced this sentiment.

But while falling volume and low volatility might usually be a good combination in such circumstances the divergent volume performance between trade in physical bonds and the exchange traded funds (ETF’s) which are based on them suggests markets might be getting less, not more, stable.

Which of course is what Minsky hypothesised – stability leads, or transitions, to instability.

Highlighting the potential for instability to be hidden in plain sight comes a note from Graeme Jarvis, a credit trader at Westpac in Sydney, this afternoon.

Jarvis is a trader who writes and whom I have followed for years. Indeed he is my favourite financial markets writer. But only recently has Westpac started packaging his views for wider distribution.

Jarvis wonders if bond markets are fundamentally broken and referencing an article in the Financial Times on Friday written by John Authers which highlights that at the same time physical bond volume has fallen 6%, the volume of turnover in ETF’s, which rely on physical prices and trade and are essentially a synthetic bond or derivative of the physical, has increased 18%.

Jarvis noted the lack of physical trade and the increase in ETF trade was interesting and warns:

What I thought was really spicy about the article was when they said that over that same time period the volume in fixed income ETFs had risen by 18%. So as liquidity in the secondary bond market declines volumes in a next derivative product actually increases. Now this is not a timing observation or really anything actionable but when you think of the characteristics of a healthy solid market, falling underlying volume yet rising ETF volume probably does not get a tick in the box.

As he says it’s not necessarily a signal to sell the market but it certainly is a warning bonds might be transitioning, or at least at risk, of a Minsky style explosion in volatility sometime this year.

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