April 30th, 2015
in Op Ed
by EconMatters, EconMatters.com
Treasury, Fed, CME & HFT Community
Since there seems to be a fundamental lack of knowledge lately regarding market crashes, I thought I would explain what happened in the epic bond market crash of last year. It seems Treasury along with the Fed and various other players from the CME and the large financial institutions have been searching for answers regarding what caused the October 15th crash in bonds.
Markets Don't Crash Up!
First of all it wasn't a crash, this is the misnomer in how mainstream financial media portrays the bond market. A market cannot crash if it goes up, it is bond prices that the financial media should concentrate on not the bond yields. Think in terms of bonds as assets like stocks, ever since global ZIRP bonds have become assets just like stocks. Bonds are played just as much for price appreciation since the ZIRP era began as they are for yield returns.
Price Appreciation versus Yield Returns
For example, GE stock owners could care less about the lower yield returns if their stock doubles and triples in value over the course of a year. And in the case of the German 10- Year Bund nobody is complaining because they were receiving a paltry .05 or 5 basis point yield return on their investment (which was the case a couple of weeks ago) when the price of the German 10-Year bund has appreciated so much over the past 14 months.
Therefore don't think of the bond market in terms of yield. Think of the bond market in terms of price appreciation. The bond market didn't crash on October 15th, it went parabolic in price appreciation, and bondholders practically wet themselves trying to execute sell orders on that morning to take advantage of their gift from Heaven after the shorts were squeezed on that momentous day.
Bonds have morphed into Stocks
Prices are a relative thing, today the price and yield might not seem like that big a deal on the 10-Year US Bond yielding 1.86%, but for bondholders who bought these bonds at the beginning of 2014 when the yield was 3%, or mid-year at 2.5%, or earlier that fateful morning at 2.20%, to wake up and have these same bonds appreciate in price with an equivalent yield being 1.86% in a matter of hours, this represented a real relative take profits moment if there ever was one for bondholders in their respective portfolios. I am describing the bonds in terms of yields just like the financial media because this is how readers can identify with the market. If I described these moves in terms of price given how bonds have been portrayed for most of the readers by the financial media it might confuse readers. Just keep in mind that when yields go lower this is not a bad thing for bondholders because as the yields are going lower this corresponds with the prices of the bonds going higher. Again think of bonds as an asset like stocks, which is what they have become in the insanity which central banks have created in a ZIRP world.
Remember when Bonds were Actually Serving a Bond Function in Markets?
Theoretically in a normalized bond market with normalized interest rates bonds trade in a price range and the 10-year bond has a yield of 3.5 to 4.5%, and then yes bondholders are in this trade to take advantage of a hedged, balanced portfolio with a steady yield which nicely offsets their more volatile brethren in the equities market. So these investors in a normalized market are playing bonds for the steady yield returns and safe haven aspect of the investment. However, those days are long gone in financial markets since ZIRP went into effect globally! What bonds were intended when originally conceived as an asset class, and what they represent or how they are being used by investors today is one gigantic paradigm shift in financial markets. The way they are being used today is only possible with major central bank dysfunction in monetary policy. Central banks have completely altered the landscape of bond markets, and in effect changed the asset class to be exactly like stocks. So there no longer is a natural market hedge in a portfolio by owning bonds, they have in essence been turned into stocks by the central banks extreme monetary policy initiatives.
October 15th, 2014
I have set the background for this story, so now I will describe what happened on that fateful day. So this was the time of the Ebola outbreaks in the United States. Also the bonds were bid all year in 2014 starting at a 3% yield and perceived as a good value going into 2014. But the bond market really changed when the ECB lowered their fed funds rate equivalent several times in 2014 to devalue the Euro currency, and signaled to financial markets that they were going to embark on their own QE Bond buying program. Once the ECB went to essentially zero for borrowing and signaled to market participants QE was on the way, investors really started to buy bonds at an even more feverish pace in 2014.
ECB Changed the Bond Market in 2014
Every dip in price was bought with a backing up the truck mentality. A good jobs report pushed down price, buyers were just waiting for the 1-3 days of selling, and then they came in buying like they never saw such a bargain. Consequently even without any European economic malaise, or Ebola outbreak, or Geo-political event like the Russia-Ukraine turmoil investors wanted to buy bonds because they all remembered the previous year when they pushed the US Treasury 10-Year Bond yield all the way to 1.40% in trying to front run the Federal Reserve's QE Bond Buying Program. They were likewise going to front run the hell out of the ECB!
2.20% Yield Level
Then Ebola hit the US, and this pushed yields on the 10-Year down to 2.20%. The 2.20% was thought to be a major support level for the 10-Year Yield. Even a fervent bond bull like Jeffrey Gundlach thought this was as low as yields could go considering the US was winding down its QE bond buying program. Consequently there were a lot of hedge funds shorting the bond market via the futures market with the thought that yields couldn't go any lower than 2.20% on the 10-Year. This all with the belief that yields were going higher, and they probably would have given the US economic data the second half of 2014 if it weren't for the ECB going ballistic in devaluing the Euro to almost parity with the US Dollar. The ECB manipulation of interest rates wasn't in the cards when many of these hedge funds started shorting the bond market in early 2014, and adding to their bets as yields went lower and prices went higher in the bond market.
Then on that fateful October 15th early morning two more Ebola cases were identified here in the US, the media hysteria over Ebola was tremendous as usual for ratings purposes, making many people think the worst epidemic imaginable. Stocks were selling off, funds were moving from equities to bonds as customary on these days. Then the US econ data at 8:30 eastern time which was a double if I remember like retail sales and PPI reports thus showing slow growth (The Retail Sales Reports always miss) and deflation fears with the drop in oil and gasoline prices. You need to realize that traders just sit on these 8:30 econ reports waiting to flush the currencies and blow the bonds out of the water on any "bullish for bonds" type reports or Fed Related Dovish Events. Retail Sales, PPI, CPI, Fed Minutes, GDP, and Employment Reports are all fair game for major juice events where currency moves involving major bond flushes (usually to the upside in 2014) occur.
Traders try to Break Markets Everyday: Stop Hunting, Support Crashing & Breakouts
Thus here we are sitting under the 2.20% model threshold at around 2.15% yield, hedge funds holding on for dear life who were short, bad econ data, Ebola cases spreading, and the bond buying bazookas locked and loaded to blow out the shorts on this trade for major pain. They knew full well that the shorts were at their mercy point, and pushing the market over the edge was going to cause short covering of an unprecedented nature. Even in normal times without an Ebola scare bond traders try to break the market from a support and resistance standpoint in the direction of the trend which was lower in yields and higher in prices for all of 2014. Just watch a routine PPI report or a retail sales number or a 'Say nothing Fed Minutes release' and watch how the currencies move and the simultaneous movement in bonds.
Traders are trying to break through levels, blow out markets, happens all the time in our current market environment of electronic trading and global market access. There is just too much firepower at the hands of the big players today, so everything is over exaggerated, moves are much greater today than in the past. Therefore what should have been a 5-8 point drop in yields in a normal, healthy functioning market turned into the blowout of all blowouts for those who pushed the bond market over the ledge. Traders walked away from one side of the market causing a massive liquidity vacuum!
Record Trading Volumes
Yields crashed from 2.15% to 1.86%, that means bond prices jumped that much higher in direct relation to the crashing yields. This moment caused the most forced buying back of bond shorts mainly in the futures markets, which then corresponds given the nature of electronic markets to the corresponding bonds themselves, which has probably ever taken place on a single trading day. The CME made out like bandits from a trading volume records standpoint, and it wasn't like the Ebola cases suddenly went away several hours later. There were no more bond shorts, they were all forced to close out their positions that morning.
Take Advantage of Price Appreciation for Massive Profit Taking Portfolio Exits
The reason yields recovered and basically ended the day back at the 2.15% yield area where they began was because a bunch of bondholders thought to themselves that for the near term those prices for their portfolio holdings were as good as they were going to get for the most part for all of 2014, and they better take advantage of this short covering gift in prices to sell into this short squeeze rally. Sure some new shorts probably also jumped in the market after the 'crash' occurred to front run the profit-taking by existing bondholders. However, the 30 basis points move back in bond yields was mainly due to all the bondholders trying to take advantage of such good profits on their investments from a price appreciation standpoint, and trying to beat everyone else to the profit-taking. Like what commonly happens in financial markets yields ended up coming all the way back to 2.33% from this 1.86% low in yields for 2014 in a slow but continuous trending move, only to go lower during the first quarter of 2015.
Bond Market Not a Healthy Functioning Market Right Now
A slow trending, grinding move in bond markets is one thing but a 30 basis point move for bond markets at the edge of a trading range is just not the sign of a healthy, functioning asset class. Remember a Nuclear bomb wasn't dropped on New York City, we had a couple of nurses at a piss poor hospital catch Ebola and a couple of meaningless econ reports in Retail Sales (with the advent of Internet Shopping) is an outdated metric, and a PPI reading that is going to be misleading due to the sudden collapse in oil and gasoline prices. These are trading events and not really great economic barometers for long term capital allocation strategies.
Excess Liquidity, Correlated Electronic Markets & Walking Away From Markets: Huge Vacuums Develop & Market Liquidity Vanishes
In a normal functioning bond market this should have been a 5-8 basis point move in bonds. The fact that a 30 basis point round tripping in bond yields is possible shows how central banks have completely destroyed the underlying structure of the bond markets. They have accomplished this by providing excessive liquidity being readily available for large market players at ZIRP borrowing costs, along with their bond asset purchases. Throw in the changing dynamics of the modern era of electronic trading where fund flow transfers from asset classes take place with a few mouse clicks or auto-programmed via trading algos which are instantaneous versus taking days in the past. These nasty side effects of modern electronic trading technology all played a part in exacerbating the bond market 'crash' on October 15th 2014. And yes just like in 2010 in equities, 2014 in bonds, and forward looking in currencies, commodities and any other electronically traded financial market it is going to happen again. The real question isn't if they are going to happen again, but when they are going to occur!
Mini "Crashes" Happen Every Week in Bond Markets
But what happened in bonds on October 15th was a short squeeze of momentous proportions all set about by big players trying to break a market, all one has to do is look at the size in the market to determine who caused the market to go over the edge. And you can start with the same players who try to break the market from a support and resistance standpoint every Retail Sales day in the bond markets. On Tuesday April 14th of 2015 we also had a Retail Sales and PPI econ reports out and the same participants in the bond market smashed the US Dollar and blew out the bond market simultaneously.
Now there was no Ebola outbreak, and shorts weren't hanging on by a thread on this day, but the explosion of price action is just not normal, and as long as markets are set up with this much liquidity available at the touch of a button or pre-configured Algos loaded for liftoff, once the other factors are in place the same market crashes are going to continue to take place.
Watch the Currency Markets for Key Culprits
Any time there are large currency moves simultaneous with the asset moves look at the large institutional banks for your culprits. These aren't insurance companies, high frequency trading firms, small to medium sized hedge funds, retail or independent traders. Who do you think holds the most bonds and currencies on their very liquid portfolio balance sheets and moves in and out of these markets on an hourly, daily, and weekly basis? Who has been caught and fined many times for both market collusion and outright market rigging? Who can afford 12 Billion Dollar fines like mere nuisances because their trading profits are so big? Who rarely has a single losing day trading? Anytime there is a large corresponding currency slam downs in a millisecond start with the big banks, the large institutional players who have huge currency capabilities necessary to move large global currency markets to this degree. Markets don't crash if the large institutional players don't stop their usual daily market making activities! A coordinated 'walking away from the market' is just as bad for financial markets as a coordinated attempt to 'break a market'! The large financial institutions participate in doing both on a regular basis in their trading activities.
An insurance company or large pension fund isn't sitting on an 8:30 a.m. econ report waiting to blow out the currency and bond markets on a meaningless data point in the overall grand scheme of things. In any investigation start with the players who have the size and motives to really move markets. It takes enormous size, and usually 'coordinated size' to move markets in a blowout manner, start any investigation with who was behind the 'enormous size'! This is who is mainly responsible for any market crash. And if a normal market participant who provides market making activities on a daily basis in a given market all the sudden on one day completely steps aside and pulls all orders at every price level this is your other clue as to who contributed to the market crash! But it sure isn't some independent trader trading with a 6 Million dollar account at a small brokerage firm that ever causes a market crash in any large market! Always follow the size or the evaporation of size as to clues regarding large market moves.
Financial Markets are Broken
In effect, financial markets are broken today! When you have this much ZIRP liquidity floating around in the financial markets on a daily basis it is the same as a drought in California setting the conditions suitable for Fire Events. Add to this ZIRP environment the complex dynamics of electronic markets, global access, the instantaneous flow of capital between markets, and traders trying to break markets for profit. This all goes into one nasty witches brew, paving the inevitable outcome for future market crashes.
Inflation Cycle is where the Market finds Religion
Just wait until inflation spikes in the next inflation cycle, and these same traders are all shorting bonds trying to break the market from the other side. Now that will be an actual market crash, and yields probably will not roundtrip in a day, but lead to crash after crash in succession, and the ultimate collapse that necessitates changes being made to the structure of the bond market and electronic markets in general. This is what lies ahead in the future, and why the Fed and Janet Yellen were so scared to raise rates a measly 25 basis points and fretted over the rise in the US Dollar at the March Quarterly Fed Meeting. They haven't seen anything yet, inflation and the inflation cycle is where the rubber meets the road. A true come to God moment on asset prices given the insanity of ZIRP by central banks. The inflation cycle, and I think in terms of just a 3% inflation number on an annual basis is going to cause the entire bond market to crash beyond anything we have seen previously. And if we get a couple of quarters with a 5% inflation rate most of the global banks will need to be bailed out again by taxpayers. They are all insolvent as we speak with a 5% rate of inflation given what they are holding on their books right now in terms of inventory and at what prices!
Drought Conditions Create Wild Fires
It is because of the extreme nature of Central Bank Policies that has all these regulatory agencies fraught with concerns over what caused these mini market crashes. It is because they know what is ahead for financial markets when the ZIRP era ends due to just a normalized inflation model and asset re-pricing. These are the unintended consequences of flawed policies. Everything has a cost, and market crashes are the cost of doing business with regard to creating asset bubbles in financial markets; central banks have no business creating conditions for the next wildfire! They know it and are scared to death of the magnitude of unintended consequences that will come to pass in financial markets on the unwinding of ZIRP. October 15th, 2014 wasn't a market crash! Stick around folks, I will show you what a Real Bond Market Crash looks like! And there is nothing the Treasury secretary or the Federal Reserve Chairperson or the CME can do about avoiding this market crash. It is as inevitable as fires in California as a result of prolonged drought conditions!