WASHINGTON TURNS BOND MARKET UPSIDE DOWN / THE FINANCIAL TIMES COMMENT & ANALYSIS

November 25, 2013 11:21 am

 

Washington turns bond market upside down

 

By Ralph Atkins in London

 

 

The financial market world order is in upheaval. The past few weeks have seen a telling change: longer-term Spanish and Italian government bonds have become more stable than US Treasuries.
 
The shift, shown in the volatility of total returns, highlights the relative calm enjoyed by global bond investors – but also how Washington has become a bigger source of instability than the eurozone.

Treasuries in transition

 

Volatility of 7-10 year government debt (To enlarge graph click here)

 

 

The risk is of being thrown into unfamiliar territory and of volatility suddenly spiking again, with the effects spreading into other markets and the real economy.

Back in mid-2011, Italian and Spanish bond markets became the centre of world concern, with changes in total returns – taking account of price changes and interest payments – varying wildly, especially compared with US Treasuries.

Since the middle of October, however, as the US Federal Reserve has moved closer to scaling down, or “tapering”, its emergency asset purchase programme, US seven- to 10-year bonds have seen larger average fluctuations.

 

“We’re in a low-risk world for eurozone periphery bonds and a high-risk world for US Treasuries because of ‘tapering talk’ – when it [tapering] starts we will see a big pick-up in US Treasury volatility,” says Ramin Nakisa, strategist at UBS.

The volatility of US Treasuries “is picking up because of uncertainty over the US economic cycle and future Fed policy”, adds Didier Saint-Georges, investment committee member at Carmignac, the French fund manager.

So far, the switch is more the result of the crisis in the eurozone “periphery” economies becoming less acute, rather than worries over the US. Short-term US debt markets, over which the central bank has greater control, remain stable. In equity markets, the Vix index of expected volatility in US shares – the Wall Street “fear gauge” – has dropped to pre-crisis levels, as has its European equivalent.

However, the volatility of Italian and Spanish bonds has been falling steadily since last year’s pledge by Mario Draghi, European Central Bank president, to do “whatever it takes” to preserve the eurozone. The ECB’s indicator of systemic financial risks in the eurozone has fallen sharply.

 

Italy and Spain have also seen an increasing share of government debt being held by domestic, rather than foreign, investors, which are less likely to sell at times of stress.

The decline matters – high volatility increases risks for investors.

Less market variation has created a virtuous circle, says Laurence Mutkin, head of global rates strategy at BNP Paribas. “The fall in volatility in the eurozone periphery bond markets since the middle of last year explains why investors are more confident about these bonds. The risk-reward ratio can remain favourable even as yields fall.”

Forces driving US debt markets are working in the opposite direction. “Volatility could be the result of the self-correcting nature of the Fed taper talk,” argues Mr Saint-Georges. “When yields rise, the threat to the economy persuades the Fed to go slower on tapering. So you get increased volatility both on bond markets and on economic activity readings.”

 

In turn, US volatility could feed back into Europe. “When you really get some volatility in the US then, yes, you will get more volatility in Europe,” says Laurent Fransolet, head of fixed income research at Barclays. However, he argues it is a different kind of volatility.

In crises that followed the collapse of Lehman Brothers in late 2008 and then the eurozone’s debt woes from 2010, markets rode a common “risk on, risk off” rollercoaster. “We’ve had five years of extreme volatility in fixed income and financial markets generally. But ‘risk on, risk off’ has gone and it is back to volatility driven by monetary policy,” says Mr Fransolet.

The next set of US jobs data could determine whether the Fed will start “tapering” its asset purchases in December – or wait until next year. Bond prices will probably yo-yo as the central bankers make up their minds.

Still, the process may prove less disruptive than many fear. Mr Mutkin at BNP Paribas argues: “With sufficient guidance from central banks, the ending of asset purchases doesn’t have to be associated with higher yields or much higher bond market volatility, if the central bank gets its communication policy right.”

And even if global volatility does pick up, it could prove shortlived. Once tapering is finished, calm might quickly be restored, especially if the first Fed interest rate rise still looks a long way off. By that time, attention could have switched back to the eurozone, or elsewhere.
 
“It is not going to last very long – Treasury volatility will fall when tapering ends,” says Mr Nakisa at UBS. “We are in a transition. It is the wood between the worlds.”

 

 

Copyright The Financial Times Limited 2013.