In the space of a few hours on Wednesday this week, the yield on the US 10-year Treasury bond tumbled from 2.19 per cent to 1.86 per cent, an eye-watering move that weaker than expected US retail sales could never explain. To put this move into some perspective, the price of the most widely followed bond in the US government market had spiked to a level not seen since May last year. It was also the first time that the yield had dipped below the 2 per cent level since the US central bank started talking about tapering its quantitative easing programme. However, by late afternoon the 10-year yield had rebounded to 2.13 per cent, almost wiping out all of the gains on the bond. A staggering $924bn (£575bn) of US government bonds changed hands in the trading session, a record amount according to data from interbroker dealer ICAP.
It was a fairly unprecedented move, at least in 'normal' markets post the financial crisis. Not even a spike in equity risk aversion could explain the rise in US government bond prices. Wall Street's fear gauge, the Vix index, spiked 36 per cent to a reading of 31 at one stage, still well below the levels during previous market sell-off in the autumn of 2011.
In my opinion, there is only one rational explanation for what was going on: an almighty liquidity squeeze and short covering by hedge funds and trading companies exiting short positions on US Treasuries. That's because some financial institutions had previously been betting that the US central bank would start raising rates next year following the end of its third round of quantitative easing this month. In turn, this will lead to rising government bond yields as the primary buyer of US Treasuries, the US Federal Reserve, starts to tighten monetary policy.
This scenario is still highly likely to play out in my view as interest rates are normalised. However, for speculators and hedge funds losing money on their short Treasury positions the pain was too much to take. In fact, clients of Wall Street giant Goldman Sachs were told to close out their short positions on the US three-year Treasury note at a thumping loss even though "the bank's macro and monetary policy baseline view had not changed in light of recent developments".
Shorters squeezed
Having entered these short positions in mid-June when the US three-year Treasury note had a yield of 93 basis points, at one point the yield had shrunk to 55 basis points on Wednesday this week, albeit it did recover to 70 basis points at the close, down around 10 basis points on the day. Given the yield moves inversely to the price of the bond, then a spike on the bond price (to drive yields down) would have crucified traders running short positions.
In a note to clients, the macro research team at Goldman Sachs stated: "The rationale behind our recommendation was that the term premium at the front end of the US curve was too low, given our forecast that the US would grow at an above-trend pace averaging 3 per cent until 2017, inflation would move towards the central bank's target, and the Fed would start to hike the policy rate in third quarter of 2015...and lift the policy rate to a 4 per cent neutral level by the end of 2018."
The bank is still maintaining its baseline view, but also notes that "the market seems clearly more concerned than we are about the effect of a deceleration in euro area and global growth on the US economy, and has repriced the future stance of monetary policy, pushing the timing of the lift-off date (of the first rate rise) from June 2015 to September 2015." The macro team at Goldman Sachs added that: "The price action has been exacerbated by positioning and market liquidity. The flows and sharp intra-day moves in the US Treasury bond market, which occurred on the back of disappointing retail sales - a quite volatile indicator - suggests that investors are covering still large short positions. This has contributed to an overshooting in the market that is pushing yields significantly below levels consistent with our macro and monetary policy views."
In other words, forced selling by highly-geared traders exiting losing short-government bond positions sparked the initial price move in fixed-income markets. The short squeeze was then acerbated by reduced liquidity in these markets resulting from tighter regulation and higher capital requirements placed on banks by the authorities. Indeed, post the 2008 financial crisis, banks have been shrinking their balance sheets and have reduced fixed-income trading activities due to the fact that they have to hold more capital for these riskier activities (so are less profitable). So, with less of a buffer in the market, this means price moves are far more accentuated. There is also a possibility that computer driven trading could have fed the price moves, too.
Furthermore, given the spike in risk aversion investors are more likely to seek sanctuary in safe-haven US government bonds in such a risk-off environment. In turn, this has acerbated the price move.
Bond market pricing out of sync
Clearly, a 10-year Treasury bond yield around 2 per cent on both UK and US government securities is out of sync with the IMF's and central banks guidance of strong economic growth over the next few years in both countries. But it would be wrong to think that one day's price action during a period of heightened risk aversion is reflective of a material change in the likely course of action the US central bank will pursue. The same is true for the UK.
Indeed, the spike in government bond prices this week fails to factor in the important point that the downward move in commodity prices and the strength of the US dollar are actually supportive of a normalisation of US monetary policy. In fact, the 24 per cent slide in US crude oil since the end of June is tantamount to a tax cut for gas guzzling US consumers. Moreover, the 8 per cent appreciation in the dollar index since May means that imports are cheaper, too. True, these factors will dampen down US inflation, but not to the extent that the US Federal Reserve will need to change its policy stance.
The same is true of the UK economy as the price of Brent Crude has fallen by 28 per cent since June and is helping to lower inflation here. But with employment at record levels, and unemployment rates at their lowest level since the financial crisis began in 2008, the margin of spare capacity is shrinking rapidly. This points to a higher inflationary outlook as wage inflation is allowed to ramp up. The risk of delaying a rise in interest rates in the UK is that if this year's falls in commodity prices prove temporary, then sterling's strength will have masked inflationary pressures that would have otherwise been seen in the official data.
True, investors are paying little attention to this right now and undoubtedly will not until the 'growth scare' spooking them ends. However, when markets return to some form of normality, then the rock-bottom yields on safe-haven UK and US government bonds, and the elevated risk premium factored into equity market valuations, and in particular in the smaller end of the market which has been savagely derated across the board, will undoubtedly unwind. There are rich pickings to be had in the debris, and the 2014 stock market sale is now on for bargain hunters.
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
