The carnage in Europe and US bonds is echoing on around the world as Aussie 10Y yields jump 15bps at the open (to 3.04% - the highest in 6 months) and the biggest 2-day spike in 2 years. JGBs are also jumping, breaking to new 6-month highs above 50bps once again raising the spectre of VAR-Shock-driven vicious cycles...
The spectre of a self-feeding dynamic is something we’ve discussed at length before, most notably in 2013 when volatility-induced selling — reminiscent of the 2003 JGB experience — hit the Japanese bond market again, prompting us to ask the following rhetorical question:
What happens to JGB holdings as the benchmark Japanese government bond continues trading with the volatility of a 1999 pennystock, and as more and more VaR stops are hit, forcing even more holders to dump the paper out of purely technical considerations?
The answer was this: A 100bp interest rate shock in the JGB yield curve, would cause a loss of ¥10tr for Japan's banks.
What we described is known as a VaR shock and simply refers to what happens when a spike in volatility forces hedge funds, dealers, banks, and anyone who marks to market to quickly unwind positions as their value-at-risk exceeds pre-specified limits.
Predictably, VaR shocks offer yet another example of QE’s unintended consequences. As central bank asset purchases depress volatility, VaR sensitive investors can take larger positions — that is, when it’s volatility times position size you’re concerned about, falling volatility means you can increase the size of your position. Of course the same central bank asset purchases that suppress volatility sow the seeds for sudden spikes by sucking liquidity from the market. This means that once someone sells, things can get very ugly, very quickly.
Here’s more from JPM on the similarities between the Bund sell-off and the JGB rout that unfolded two years ago:
The sharp rise in bond volatility over the past week or so is reminiscent of the VaR shocks of October 2014 in US rates and April 2013 in Japanese rates. The common feature of these rate volatility episodes was that there was no clear fundamental trigger. Instead, positions and flows experienced a sharp swing making these VaR episodes appearing more technical and unpredictable in nature. In October 2014, a violent capitulation on short positions at the front-end of the US curve had caused a collapse in UST yields. In April 2013, profittaking in long duration exposures post BoJ's QE announcement caused a sharp rise in JGB yields that started reversing two months after.
What is causing VaR shocks and why are they happening often? We argued before that one of the unintended consequences of QE is a higher frequency of volatility episodes or VaR shocks: investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self- reinforcing volatility-induced selling. This, we note, is how QE increases the likelihood of VaR shocks.
The proliferation of VaR sensitive investors, such as hedge funds, mutual fund managers, risk parity funds, dealers and banks raise the sensitivity of bond markets to self- reinforcing volatility-induced selling. These investors set limits against potential losses in their trading operations by calculating Value-at-Risk metrics. Value-at-Risk (VaR) is a statistical measure that investors use to quantify the expected loss, over a specified horizon and at a certain confidence level, in normal markets. Historical return distributions and historical market volatility measures are often used in VaR calculations given the difficulty in forecasting volatility. This in turn induces investors to raise the size of their trading positions in a low volatility environment, making them vulnerable to a subsequent volatility shock. When the volatility shock arrives, VaR sensitive investors cut their duration positions as the Value-at-Risk exceeded their limits and stop losses are triggered. This volatility induced position cutting becomes self- reinforcing until yields reach a level that induces the participation of VaR-insensitive investors, such as pension funds, insurance companies or households.
The VaR shock in the JGB market in April 2013 contained most of the above characteristics. By looking at quarterly Flow of Funds data from the BoJ, it was Japanese banks, Broker/Dealers and foreign investors who sold JGBs at the time. And it was VaR insensitive investors, such as Pension Funds and Insurance Companies and Households (via investment trusts) who absorbed that selling along with the BoJ.
As we warned last time, it appears the fireworks are far from over.