Bond Market Looking Shaky!

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When I interviewed Money Week’s Tim Price recently, he described the current bon market as bonkers, asking us to take an investment risk for a zero or even a negative return. Those in the know increasingly feel that the bond market could be about to trigger the next big crash.
It’s a truism in financial markets that all asset prices eventually revert to their long term mean average. After a forty year bull market that has brought prices so high that yields are now negative, we have to ask if the market is overdue a serious correction.
And there’s more than just the weight of history behind the argument. New regulations have made it increasingly expensive for banks to hold bonds in stock. When they have a good stock they can act as a market maker. This means they can smooth the peaks and troughs in demand between buyers and sellers, a bit like a shock absorber smoothes the ride in your car.
But the rules of the game have changed. Tighter bank regulation introduced since the last crisis is having unintended consequences. It’s making it much more expensive for banks to hold bonds in stock, so they’ve drastically cut back. Have you ever driven a go kart that is two inches off the ground with no shock absorbers? I have, and it kept my osteopath in work for weeks.
We got just a hint of what might be in store in October. The normally pedestrian ten year US Treasury bond is probably the most important instrument in the financial world. It’s yield plunged from two point two per cent down to one point nine per cent then back to two point two per cent all in the space of fifteen minutes. The reason? A lack of liquidity in the market. No stock at the bank. No shock absorber. The result is known as a Flash Crash.
Then we’ve got the phenomenon of programmed selling. The ability to buy or sell any quantity of an asset at the click of a mouse is impressive enough. But sophisticated hedge funds go way further than that, operating in nanoseconds. When a lot of people want to sell and there are no buyers, prices can crash in an instant. Any lack of liquidity will be massively amplified.
The Royal Bank Of Scotland is saying that liquidity in the US credit market has gone down a scary ninety per cent in the last decade. It’s something that the average investor will never see or be aware of, until the crash happens.
And it may not be government bonds that trigger the crash. There’s been a deluge of corporate bonds in recent years, up from a hundred and fifty six billion pounds worth issued in two thousand and five to two hundred and sixty nine billion last year. With earnings falling in many American companies there could be panic selling of bonds issued by those companies or at least some real challenges in them raising further finance that could cause cashflow problems in their operations.
And finally there’s our old friends the banks themselves. As big investors in the bond markets they are leveraged within an inch of their lives. Even with the higher capital ratios imposed by the latest Basel requirements they’d only need their holdings to decline in value by three and a half to four per cent to wipe out their balance sheets. That would mean a visit to the politicians, cap in hand and with an uncharacteristically humble look on their faces, to request Bailout two point zero.
Then we’ve gone full circle with the real victim being the good old taxpayer. Yup, you and I could soon be footing the bill all over again. If you’re buying the BS that everything is once again hunky dory in the world’s financial markets, be very careful out there!

Comments

Bill Smith says:

We are witnessing the beginning of the bond crash, which will bring down equities and the economy itself.

Mat Green says:

Interesting/scary topic. What can the man on the street do about it? Is average Joe going to start accumulating CDOs alongside his Tesco clubcard points and a couple of premium bonds?

Maciej Banach says:

I agree with you. Question is when?

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