On Monday this week, the most important market in the world went, to use the technical term, completely bananas.
Government bonds have a habit of rallying when the going gets tough, which it indisputably did when Silicon Valley Bank imploded. So a jump in US Treasury debt prices off the back of this makes sense. The turmoil prompted nervous investors to look for a safer hidey hole.
The failure of SVB, and a clutch of other regional US banks, suggests the US Federal Reserve will be more lenient in its interest rate rises from here for fear of tripping up the banking sector. It might also mean the central bank won’t need to be as aggressive as it has been, if commercial banks tighten up lending standards. Both factors would boost the appeal of bonds. Plus, a lot of deposits getting yanked out of banks found their way in to US money market funds, where they were turn ploughed into Treasuries.
But there are bond rallies and there are bond rallies. This time, the market reaction in Treasuries was nothing short of apocalyptic. Two-year Treasury notes, the most sensitive instrument in the debt market to the outlook for interest rates, rocketed higher in price. Yields dropped by an eye-popping 0.56 percentage points, having already dropped by 0.31 percentage points the previous Friday.
To put Monday’s move in context, it represents a bigger shock than in March 2020 — not a vintage period for global markets. It was bigger than on any day in the financial crisis in 2008 (ditto). You have to go back to Black Monday of 1987 to find anything more severe. Trading volumes were off the charts. Monday was the biggest day for trading in Treasuries ever, with around $1.5tn changing hands, well above the average of $600bn or so.
Yet at the same time, other asset classes barely broke a sweat. Some individual US bank stocks with a strong whiff of tech about them got slammed, as you might expect. But the S&P 500 benchmark index of US stocks closed pretty much flat. The picture is less clear cut, but similar, in Europe, where the Stoxx 600 stocks index closed around 2.4 per cent lower on Wednesday — a decent hit, but not a disaster — while two-year German debt yields sank at the fastest pace since 1995.
This all tells you something weird is going on in the bond market. Christian Kopf, head of fixed income at Union Investment, points the finger of blame at the sector he previously worked in: hedge funds. The Treasuries market has become, he said, a “hall of mirrors”, packed full of hedge funds trading blows with the Fed.
Macro hedge funds are flush with cash after a barnstorming 2022, when they bet the farm on a rapid rise in interest rates, and won. They have sucked in new money from investors willing to overlook the fees for a piece of the action. They are displaying far more muscle in the market than more traditional asset managers such as Union Investment, Kopf says.
As Kevin McPartland, head of market structure research at Coalition Greenwich, says, it’s really hard to quantify this. “The data just doesn’t exist.” But the growing role of non-bank traders in the market is clear. Six years ago, banks trading with each other accounted for about 40 per cent of the market, he says. It’s now closer to 30 per cent.
However, for hedge funds, and other types of speculators, the problem this week was that on aggregate, they went in to 2023 running pretty much the same bets as in 2022, positioned to win in an environment where the Fed pushes interest rates higher.
When SVB sparked a search for safety in Treasuries, that bet took a hit. When it did, many hedgies were forced to close out their positions, effectively making them buyers of Treasuries. That blew up more negative bets, and forced more buying. It was a classic short squeeze, and a big one at that. It has left a string of big-name macro hedge funds wearing ugly losses. “The most important market in the world is being dominated by a bunch of hedge funds,” says Kopf.
Still, it does make sense for yields to be lower. The Fed will not overlook the SVB disaster. Neither will the European Central Bank, which has a banks scare on its doorstep, too, with Credit Suisse. “These events can very well lead to a recession,” said Pimco’s north American economist Tiffany Wilding. So far, the ECB has stuck to the script, opting for a half-percentage-point rise in rates this week. Yet it’s rational to anticipate milder global rate rises from here.
But at the same time, it is worth exercising caution before assuming that the bond market is throwing out reliable information about what the Fed and other central banks will do next. The market move is not necessarily saying investors genuinely think interest rates are going to fall any time soon.
There is some irony here. One of the reasons bond markets are more prone to volatility now than they were a decade ago is that banks are much safer, and less willing to hold on to risk, leaving hedge funds to fill the gap. But the past week goes to show that jitters over banks can still blast in to the world’s most important market, and that the outsized role of hedge funds can make a bad situation appear even worse.