Bond markets roiled by highest volatility since 2008

Even the Great Financial Crisis failed to generate the level of chaos embroiling global bond markets today.

In 2008, and again in early 2020 during the shocking early days of COVID-19, bond yields collapsed as investors braced for tumbling interest rates.

This time, however, traders are torn between two scenarios. They can bet on rates continuing their historically fast upward march to combat inflation, as U.S. Federal Reserve chair Jerome Powell suggested last week was still necessary, and that the European Central Bank reinforced this week by hiking its own benchmark rate by half a percentage point.

Or fixed income investors can decide the contagion effects of regional bank failures in the United States and the near-collapse of Credit Suisse in Europe will spawn a broader economic crisis requiring interest rates to fall back toward zero.

They cannot do both, and that unprecedented level of indecision is creating volatility the likes of which Andrew Becker has never seen during nearly two decades in debt markets.

In prior crises, bonds “would just be consistently moving in one direction, or pausing, but this is big spikes in both directions,” Mr. Becker, managing director of debt capital markets for TD Securities, said in an interview.

“It is much more uncertain day by day how the market is going to react and what it is going to react to [because] a lot of times in the fixed income world, a lot of stuff is priced into the market before it happens, but you don’t know what is happening now, so it is reacting to headlines more than I have ever seen in my career,” he said.

Government of Canada bond yields, for example, have swung up or down by 10 to 20 basis points every day this week. (There are 100 basis points in a percentage point). Those yields usually don’t move more than five basis points in a typical trading day.

“On the Street, there has been less liquidity because there is the unknown of where the market is and where trades will clear,” Mr. Becker said. “It has been highly volatile and there is a lot of time and caution [taken] before every trading movement.”

For now, the chaos appears contained to the bond market, with volatility in equities and even currencies being relatively unchanged despite the dramatic events of recent days. Yet it is difficult to overstate how much bond market volatility has spiked in such a short period of time. The Merrill Lynch Option Volatility Estimate, or MOVE Index, which tracks the implied volatility of U.S. Treasury bonds, hit its highest level since 2009 this week.

“One key difference from 2020 or 2008, though, is back then the risk was a fall in bond yields because a pandemic or a financial crisis are displacement shocks where rates go to zero,” said Jonas Goltermann, deputy chief markets economist at Capital Economics in London.

“That was one-way risk – there was no way those events were going to lead to inflation. But now, we are coming into this with really high inflation and, up until barely a week ago, that was the main risk for investors to worry about,” he said.

From the perspective of a bond trader, Mr. Goltermann said, markets have gone from a situation in which the risk was mostly to the upside, in that rates might peak at 6 per cent or 7 per cent this year, before falling back to around 4 per cent.

“Now, you’ve gone to a world where you could still end up with 6- or 7-per-cent rates, but the bottom has gone to zero,” he said. “Your range of expectations has widened a lot because if things get really bad in the economy, rates could be cut to zero by the end of this year. And then the volatility, which was already extremely high, has just gone through the roof because nobody knows the answer.”

One factor that makes the current situation different from 2008, according to Tiffany Wilding, North American economist at Pacific Investment Management Co. (Pimco), is that “at least for right now we understand the animal we’re dealing with.”

“In 2008 we didn’t really know the value or the credit quality of assets that were sitting on bank balance sheets,” Ms. Wilding, who is based in Newport Beach, Calif., said in an interview. “We are probably not on the precipice of outcomes that are similar in 2008.”

There is still the potential for contagion and spillovers in the wake of last week’s failure of Silicon Valley Bank, she said, as credit growth was already starting to slow as a result of the rapid rise in interest rates over the past year.

“SVB is not an idiosyncratic issue happening in a vacuum, it is symptomatic of actually how tight financial conditions are,” Ms. Wilding said. “This is the way monetary policy works though and it is frankly what we need to see in order to get inflation to come down… though this also pulls forward the risk of recession to where maybe we have it sooner rather than later.”

Most worrying to Mr. Goltermann is the sheer speed at which recent events have unfolded.

“From a positioning perspective, you’ve gone so quickly from trying to price [Fed chair] Powell’s hawkish comments to having to worry about the possibility of rates hitting zero as well, so I don’t envy the bond market or bond traders at all right now,” he said. “The market is not so much worried about what we know so far. We’re worried about what we don’t know yet.”