A little less than a month ago in “Two Years Later, The VaR Shock Is Back,” we outlined the similarities between the recent bout of bund selling and similar instances of safe haven havoc that have unfolded in the past.
More specifically, we discussed two self-fulfilling feedback loops that likely contributed to the sell-off. One of those self-feeding dynamics is known as a “VaR shock” and the concept is really quite simple. Here’s how we described it:
A VaR shock 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.
We went on the outline how QE sets the stage for episodic credit carnage:
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.
Last week, the bund battering was back. Here’s Goldman:
German long-dated government bonds (Bunds) have sold off aggressively this week. Returns on 10-year and 10-to-30- year bonds are negative to the tune of 6% and 16%, respectively, from the April 20 highs. Long-dated yield levels are back to roughly where they were in the last quarter of 2014, but their volatility is much higher. The 10-year benchmark rate has approached our end-2015 forecast.
Our correlation analysis indicates that the back-up in 10-year Bund yields has been affecting other markets and was pushing US Treasury yields higher. Exhibit 1 depicts the cumulative bullish or bearish signals generated by each of the four major bond markets, once contemporaneous and lagged inter-relations between rates are accounted for. As can be seen, Bunds are still in ‘in the driver’s seat’ in G4 rate markets, only this time they are moving ‘in reverse gear’. After contributing to a decline in global long-end rates since the Spring of 2014, they are now pushing them higher.
QE distortions: As we have discussed elsewhere, the way in which the ECB is conducting QE is leading to a ‘see-saw’ effect in the price action, particularly in markets with scarce supply. Consider that German 10-year yields were trading at around 35-40bp at the time of the March 5 press conference when President Draghi stated that the Eurosystem would not buy bonds yielding below the deposit rate, setting in motion a self-reinforcing price action largely unconnected to macro information. Seen in this light, around half of the sell-off from the 5bp lows on April 20 can be seen as the unwind of a ‘rational bubble’.
Picking up where Goldman leaves off, if half of the sell-off represents the unwind of a "rational bubble" (where we assume "rational bubble" means the rapid yield compression that occurred when investors "rationally" anticipated that the entire bund curve was destined, by the design of PSPP, to converge on the depo rate) then the other half may represent a forced unwind into an increasingly illiquid market after Mario Draghi essentially warned that hightened volatility is set to become a permanent fixture in EU credit markets.
For their part, Citi suggests that although the April/May bund rout may have forced hedge funds and banks to recalibrate, longer-term holders have not yet moved to adjust to the new reality and while the ECB seems ambivalent — content to bask in PSPP's "success" — EGB bond risk has soared.
Coming back to concept of bond market risk, we would expect high frequency investors (banks & HFs) to have reduced their risk-processing ability already in the sell-off four weeks ago. Other, less frequently trading investors (for example foreign central banks, insurance and pension funds, but also benchmarked mutual funds) might take some more time before adapting their limits to the new volatility environment. At the same time, the ECB – a large absorber of risk – is not altering its activity and even the front-loading is marginal (so far).
VaR-measures are a better measure than just volatility or dv01 in the current environment as the total market risk is a function of outstanding market value, duration and volatility (we’re simplifying a lot here). The question then is: Do investors want to own bonds at 1% or 1-2bp yield per bp of realized vol, if risk is exploding (Figure 14)? Standard theory tells us that investors want to be compensated for their portfolio risk. That is the link between risk, term premium and bond yields. Figure 15 shows that the EGB market is at historical highs in terms of total market risk!
With hoplessly illiquid core markets set become hoplessly illiquid-er during the summer "lull" (EGB net supply, QE inclusive, was set to be deeply negative in July and August and it isn't clear to what extent font-loading will serve to mitigate supply constraints), investors should probably take Mario Draghi's advice and prepare for severe turbulence.