Why the bond market has become jumpier

JAMES MADDISON was sure he had scored. As his free kick arced over the wall of Arsenal players, a goal seemed certain. Somehow Arsenal’s goalkeeper, Aaron Ramsdale, got a hand to the ball and kept it out. “Best save I’ve seen for years,” said Peter Schmeichel, a former goalie. Others noted a crucial detail. Before the ball was struck, Mr Ramsdale was on his toes, his weight distributed evenly, ready to jump in either direction. By keeping perfectly balanced, he made a wonder-save possible.

Balance (or the lack of it) matters in financial markets, just as in football. A market in which bets are slanted in one direction is vulnerable to a big swing in prices the opposite way. Where positions are lopsided traders can be wrong-footed by even a tiny change in sentiment or in the news. Some of the recent volatility in global bond markets can be put down to skewed positioning. When liquidity is patchy, as in today’s Treasury market, the results can be some surprisingly large shifts in bond yields.

To understand all this, imagine you are pondering a trade. You notice that covid-19 infections are rising in Europe and that governments are imposing partial lockdowns. Meanwhile there are signs that America’s economy is picking up steam. You conclude that the Federal Reserve will have to raise interest rates sooner than people expect and a lot sooner than the European Central Bank. A way to profit from this analysis might be to sell the euro against the dollar.

Before you go ahead, you would be wise to check how other traders are positioned. America’s Commodity Futures Trading Commission publishes regular reports on the positions of traders in currency futures and options. If, say, there were already a lot of euro shorts, you should feel less gung-ho. After all, if many traders have already sold the euro, there are fewer potential sellers to drive it down in the future. And there are perils when a lot of investors are betting one way. In the event of unexpected news that is positive for the euro, the speculators who are short the currency would be nursing losses. Some would be forced to buy back the euros they had sold. As more traders scrambled to cover their short positions, the euro would appreciate sharply. This is a classic “short squeeze” or “position washout”.

That brings us to bond-market volatility. Inferring traders’ positions from bond futures is tricky, says Kit Juckes of Société Générale, a bank. The nature of finance is to borrow short and lend long. This “natural positioning” will tend to obscure other speculative bets, says Mr Juckes. Perhaps this is why a lot of the recent discussion of volatility has been focused on liquidity—how easy it is to get in or out of a position quickly. A report this month by a working group drawn from America’s Treasury, the Federal Reserve and other regulatory bodies provides an example. It blames evanescent liquidity for the dramatic jumps in bond yields in, for…