What does the UST bond market and Taylor Swift have in common? They both like to “Shake it Up”

Just over a month ago the US Treasury market had one of the wildest days in recent memory. On the morning of October 15th, 2014, UST 10s surged 14% and then almost immediately sold off to end the day near flat. This >30bps move rocked the bond world but so far hasn’t garnered much attention from news sources. This post touches on how the UST market works and will hone in on some of the possible explanations to this crazy volatility and where we go from here.

 bloomy final

Figure 1: UST 10 year yield – Oct 15th 2014

Source: Bloomberg

 

THE RISK FREE (LOL) US TREASURY BOND MARKET

Recall Finance 101 where your professor makes the outlandish claim that a country’s national debt is risk free. Also recall the one kid in your class (who continuously fishes for participation marks) who argues this point with concrete examples. Good thing the award winning finance concepts such as CAPM and the Fama-French model assume a “risk free” rate (read sarcasm). The jury is still out, but lets take a moment to delve deeper into the US Treasury market participants.

 

1. The US Government

 uncle-sam-broke

 

If you were to tell your non-finance buddy that the US government can borrow billions of dollars for 10 years @ ~2% (or better yet, 30 years @ ~3%) you might assume he would think you are full of crap. Welcome to the US bond market where normal rationalization does not apply.  The government finances itself with an absurd amount of debt at super cheap levels and will continue to do so until it figures out how to properly balance their budget. I wouldn’t hold your breath.

 

2. Primary Dealers

Sign at Goldman Sachs, 133 Fleet Streetlogo-ms

 

Hey! Pretend I am the US Treasury and I need to borrow cash. Instead of just asking market participants to kindly buy my debt and hope for the best, why not force them to! Say hi to primary dealers who are FORCED to bid on UST’s at the debt auctions. The theory behind this is that the banks competitively bid on product so they can turn around and sell it to their investor base (you guessed it, at a profit!). In secondary markets, these dealers claim to provide liquidity and “sharp” pricing for their clients who definitely have their client’s best interest in mind.

3. Investors

 Bill Gross, co-founder and co-chief investment officer of PIMCO arrives to speak at the Morningstar Investment Conference in Chicago

You. Me. Bill Gross. We are the providers of capital and the US government is in desperate need for it. Hate to break it to you, but we can’t move markets and as it turns out the very traders who trade these bonds for a living don’t know what moves them either (as you will see below.)

 

POSSIBLE EXPLANATIONS FOR THE ROLLER COASTER RIDE IN UST 10s ON OCT 15/14

 1. BAD DATA

Economic fundamentals are supposed to provide insight to financial market participants to make educated investment decisions. As it turns out, every syllable spoken from the FED may move bond markets more than real economic data released by the government. Regardless, on this fine day in bond land, numerous data points missed analyst’s expectations including worse than expected retail sales, producer prices, and an empire manufacturing survey. This bucks the recent trend of strong US economic data, but these data points aren’t nearly as important as the monthly NFP report that trading floors bet on (both via their trading book and office pools). These three data releases are important, sure, but are absolutely not enough to move the most liquid asset class in the world 31 bps. There must be something else going on here.

2. BIG FLOW HIT THE MARKET

I love this one. When you have no idea why the market you trade moved so viciously, blame it on a “big flow away.” This is Wall Street lingo for a large trade done with another dealer by a client who didn’t deal with you. Too many of these put sales people and traders out of a job because they aren’t supposed to prop anymore – and therefore must rely on client flow to make money. Numerous sources cite a large scale repositioning by a hedge fund caused this massive move (anyone remember May 2010?). Sure. A hedge fund being short squeezed is plausible but still does not account for a 31 bps move!

3. EBOLA SCARES

This explanation won’t have any laughs, as it is a real world problem faced by the society.  The spread of the Ebola crisis has the potential to dramatically change our world and with this investors tend to flock to safety when times are bad. This argument has sound backing as USTs, the world’s safe haven, get bid up when crap hits the fan. Our old friend, the risk-on/risk off trading strategy, may account for at least a portion of the rally in USTs, but it can’t be entirely to blame.

4. TECHNICALS

Ah yes. After all else fails, blame big swings in asset prices on “breaking key technical levels.” This argument is laughable at times, but in this case does carry some weight. The 2% yield on 10s is a massive psychological level. Why you might ask? Well, the first number starts with a 1 and not a 2, that’s why! Breaking this technical and psychological level would have provided added momentum for the yield to melt down. The fault in this argument is that the bond quickly sold off bringing the yield back near opening market levels erasing almost the entire move.

WHERE DO WE GO FROM HERE?

As a trader, you hope you don’t get the tap on the shoulder or the call from HR as you were on the wrong side of the trade. As the government, you blame this on High Frequency Traders and all the evil hedge funds out there. As an investor, you disregard it since you shouldn’t be day trading UST 10s in the first place!

 

Good Luck out there-keep your head up and your mind sharper.

Nick Warwick is an active member within the Rotman Asset Management Association. He will be graduating from the MBA program at the Rotman School of Management in 2016. Nick can be reached nick.warwick16@rotman.utoronto.ca
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