Ever since last week—when Treasury yields for 10-year debt fell 20% in about six minutes—bond market watchers have been scratching their heads trying to figure out what happened.
A 20% move would be large even for the stock market, but bonds are prized for their stability, and that is especially the case with Treasury bonds. So, the big drop was a sign to many that something was wrong in the bond market. It didn’t take long for Wall Streeters to point a finger at the thing they have long suspected would take markets down: regulation.
Last Thursday, Michael Cloherty, head of U.S. rate strategy at RBC Capital markets, wrote in a research note that, even to people who have long suspected that the “shock absorbers” in the market have been eroded, the move in the bond market was scary. He titled the report, “Honey I broke the bond market.”
Last Friday, the Financial Times ran a story with the headline, “Bankers blame bond market volatility on tighter regulation.”
The criticism focuses on regulations put in place after the financial crisis. Many of those regulations make it harder for banks to hold onto large amounts of risky bonds or to buy or sell bonds with their own money in order to turn a profit, like a hedge fund would. Those regulations aimed to make banks less risky. And, indeed, the banks seem to own fewer bonds than they used to.
But some have claimed that the regulations would have the opposite effect on the bond market. Unlike the case of the stock market, nearly all bond market trades happen in the so-called over the counter market, not through an exchange. That means all bond trades have to go through one of the big banks. If banks can’t hold a bond, they will be less likely to buy up the bonds that others are selling, or have bonds to offer when people want to buy. The fear for the past year or so is that when bond investors eventually decide it’s time to sell, prices will plunge. Or, put another way, when everyone heads for the exits, the banks will no longer be holding the door, and everyone else will get trapped.
Somehow, the sharp drop in yields last week proved this theory to a bunch of people, though I don’t understand why.
First of all, when bond yields fall, prices rise. So if you want to blame regulation, all you can say is that it made some people more money than they should have.
Also, the Treasury market is the most liquid bond market of all. So if you are more likely to see volatility because banks are holding fewer bonds, you are likely to see it in mortgage bonds or other structured credit. And those markets were pretty quiet last week. What’s more, the Volcker Rule, which is meant to limit the trading banks can engage in on its own and is an object of Wall Street’s hatred, specifically exempts government debt. It’s one of the few investment types that is not covered by the rule. The result: banks actually hold more Treasury bonds than they did before Volcker was passed two years ago.
The Merrill Lynch MOVE Index tracks volatility in the bond market. It was up last week to a little over 100. But that’s about what the index has averaged going back to 1995. That index spent most of 2008 and 2009, before the current regulations were put in place, well above 100. The index peaked at 214 in late 2008.
So, what happened last week? Rick Rieder, chief investment officer of fundamental fixed income at BlackRock, says the market had become crowded coming into last week. Lots of hedge funds and other institutional investors were betting on the dollar, and betting against, or short, the euro and short-term bonds. When bad economic news started coming out last week, every one wanted out of those trades and flooded into the safest place they could find, the Treasury bond market.
Treasuries are probably not as safe as they used to be. But that’s because yields are low, not because of regulation. But that’s not how the market sees it. In fact, if anything, last week’s move in bonds should prove that regulations have done very little to hurt the Treasury market or its perceived safety, not the opposite.
