On Monday of this week, the most important market in the world went, to use the technical term, completely bananas.
Government bonds have a habit of rallying when the going gets tough, which they undoubtedly did when Silicon Valley Bank imploded. So a jump in US Treasury debt prices as a result of this makes sense. The turmoil prompted nervous investors to seek a safer hidden hole.
The failure of SVB, and a group of other US regional banks, suggests that the US Federal Reserve will be more lenient in its interest rate hikes from here, lest it stumble the banking sector. It could also mean that the central bank will not need to be as aggressive as it has been, if commercial banks tighten lending standards. These two factors would increase the attractiveness of bonds. In addition, many deposits withdrawn from banks ended up in US money market funds, where they were turned into Treasury bonds.
But there are bond rallies and there are bond rallies. This time, the reaction of the Treasury market was nothing short of apocalyptic. Two-year Treasury bills, the debt market’s most sensitive instrument to the outlook for interest rates, soared. Yields fell 0.56 percentage points, having already fallen 0.31 percentage points the previous Friday.
To put Monday’s decision into context, this represents a bigger shock than March 2020 – not a vintage period for global markets. It was bigger than any day of the 2008 financial crisis (ditto). You have to go back to Black Monday in 1987 to find something more severe. Trading volumes were off the charts. Monday was the biggest trading day in Treasuries ever, with around $1.5 billion traded in hands, well above the average of around $600 billion.
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Yet, at the same time, other asset classes barely transpired. Some individual U.S. bank stocks with a strong tech smack have come under fire, as one might expect. But the benchmark S&P 500 index of US stocks closed roughly flat. The picture is less clear, but similar, in Europe, where the Stoxx 600 stock index closed down around 2.4% on Wednesday – a decent success, but not a disaster – while German debt yields at two years fell at the fastest rate since 1995.
All of this tells you that something weird is going on in the bond market. Christian Kopf, head of fixed income at Union Investment, points to the industry he previously worked in: hedge funds. The Treasuries market has become, he said, a “hall of mirrors,” filled with hedge fund trading moves with the Fed.
Macro-hedge funds are teeming with cash after a storm in 2022, when they bet the farm on a rapid rise in interest rates, and won. They sucked in fresh money from investors willing to ignore the cost of part of the action. They display a lot more muscle in the market than more traditional asset managers such as Union Investment, Kopf says.
As Kevin McPartland, head of market structure research at Coalition Greenwich says, it’s really hard to quantify this. “The data just doesn’t exist.” But the growing role of non-bank merchants in the market is clear. Six years ago, banks trading with each other accounted for about 40% of the market, he says. It is now closer to 30%.
However, for hedge funds and other types of speculators, the problem this week was that, overall, they went into 2023 making much the same bets as they did in 2022, positioned to win in an environment where the Fed pushes interest rates higher.
When SVB triggered a search for safety in the treasuries, that bet took a hit. When this happened, many hedgies were forced to liquidate their positions, making them buyers of Treasuries. This blew up more negative bets and forced more buys. It was a classic short compression, and a big one too. This left a series of large macro hedge funds bearing ugly losses. “The largest market in the world is dominated by a group of hedge funds,” says Kopf.
Still, it makes sense that the yields would be lower. The Fed will not overlook the SVB disaster. Neither does the European Central Bank, which also has a fear of banks on its doorstep, with Credit Suisse. “These events may very well lead to a recession,” said Pimco’s North American economist, Tiffany Wilding. So far, the ECB has stuck to the script, opting for a half percentage point rate hike this week. Still, it is rational to expect more subdued global rate hikes from here.
But at the same time, caution should be exercised before assuming that the bond market is issuing reliable information about what the Fed and other central banks will do next. Market developments do not necessarily mean that investors sincerely believe that interest rates will fall anytime soon.
There is a certain irony here. One of the reasons bond markets are more prone to volatility today than they were a decade ago is that banks are much safer and less willing to cling to risk, leaving hedge funds fill the void. But the past week shows that bank jitters can still explode in the world’s most important market, and the outsized role of hedge funds can make a bad situation even worse.
katie.martin@ft.com
