Treasuries Wilder Than Ever as Ultrafast Bond Traders Rise UpBy and
Big swings occurring almost twice as much as statistical norms
HFT firms may create an illusion of liquidity, N.Y. Fed says
In the year since Treasuries suddenly went haywire in the bond market’s version of the “flash crash,” unusual bursts of volatility have become more common than ever before.
The $12.9 trillion U.S. government bond market -- long considered the deepest and most liquid in the world -- is now plagued by more bouts of turbulence than at any time since at least the 1970s. By one measure, outsize swings are occurring almost twice as often as statisticians would normally expect, according to data compiled by TD Securities.
“This isn’t your grandfather’s market anymore,” Steven Meier, the head of cash, currency and fixed income at the money-management unit of State Street Corp., which oversees $2.4 trillion, said from Boston.
A common refrain is that rules intended to limit financial risk-taking have made Wall Street bond dealers far less willing to make markets in Treasuries, which has exaggerated price swings and led to brief periods of illiquidity as investors try to decipher the Federal Reserve’s intentions on interest rates.
But perhaps just as important is the rise of lightning-fast computer trading, which has caused Treasuries to behave more like equities and raised thorny questions about the underpinnings of the world’s risk-free asset. On Friday, researchers at the New York Fed said they found evidence that high-frequency traders may be creating an illusion of liquidity, especially when investors look to move large blocks of Treasuries.
While nobody is saying the U.S. government bond market is broken and New York Fed researchers also concluded that HFT firms bring more accurate pricing and reduce the cost of trading, the stakes are high. Any worries about undue volatility in Treasuries have the potential to threaten confidence in a market that’s the benchmark for borrowers everywhere in the world.
And as the Fed moves closer to ending its near-zero rate policy, the potential for more disruptions akin to what happened on Oct. 15, 2014 -- when a flurry of trading by HFT firms fueled a 0.16 percentage point plunge then rebound in 10-year yields in a 12-minute span -- has become a pressing concern for investors and policy makers alike.
“Liquidity is an issue when the algos kick in and do crazy stuff,” said Stewart Taylor, a money manager at Eaton Vance Corp., which oversees $313 billion. Although they’ve pushed the cost of trading lower, “to me, it’s not really worth the trade-off. For someone who legitimately has trades to do, you can’t execute quickly enough anymore.”
Ultra-fast moving firms, which typically trade Treasuries in microseconds using sophisticated computer algorithms, account for at least half the transactions on electronic platforms, research firm Tabb Group said in a July report. A decade ago, much of Treasury trading was done over the phone with Wall Street bond shops.
“It’s even hard to think about it when things are happening at that rate of speed,” New York Fed President William C. Dudley said at a market liquidity forum on Sept. 30. “There’s a lot more work needed to really understand this area.”
The trend toward automation, and away from human traders, might be spurring big swings in Treasuries to occur more often, according to TD.
Daily moves in 10-year Treasury yields have exceeded one standard deviation -- which is equal to about 3.4 basis points, or 0.034 percentage point -- about 58 percent of the time this year. That’s the highest reading going back to 1975. Based on a normal range of probabilities, moves of such magnitude should only occur 32 percent of the time.
The dislocations are so prevalent that they even exceed that of U.S. stocks, and is an “ominous” sign that bond market liquidity is impaired, according to TD’s Priya Misra.
“Volatility is here to stay,” said Misra, the head of global interest-rates strategy at TD, one of 22 primary dealers that trade directly with the Fed. “Nowadays, you’re getting bigger moves than you were before.”
In addition to the New York Fed’s finding that rapid-fire traders are making it hard for investors to assess market depth, the International Monetary Fund also noted that on Oct. 15, they triggered a “feedback loop” in Treasuries, where HFT firms trying to reduce risk beget more volatility with more trades.
Increasingly, the turbulence buffeting Treasuries has little to do with what’s actually going on in the U.S., as financial stress spills over from one asset class to another and into different global markets, according to the IMF. And that comes just as investors are trying to figure out exactly when the Fed will raise rates.
“We’re looking at everything now,” State Street’s Meier said. “Treasuries versus other sovereign debt -- and dare I say, even Chinese stock prices -- for indications of normalcy or extreme levels of volatility.”
HFT firms aren’t the root cause of fluctuations in Treasuries and the rise of computer-driven trading has only helped to increase the market’s efficiency, according to Bill Harts, the head of Modern Markets Initiative, the HFT industry’s advocacy group.
“The technology doesn’t cause price swings,” he said. “Banks are using automation, brokers are using automation, and HFT is using automation. It’s something that’s used to make markets more efficient.”
Long-term investors like OppenheimerFunds Inc.’s Krishna Memani also say that they can always wait out any periods of turbulence because they’re not looking to get in and out of Treasuries as frequently.
“We are investors, not traders,” said Memani, who oversees $220 billion as the chief investment officer at OppenheimerFunds. “If we think the market is going nuts, we’ll just wait for it to get better.”
And thus far, global turmoil has only increased demand for U.S. government debt. The volatility on Oct. 15, and more recently, on Aug. 24, were actually “flash rallies” with everyone piling into Treasuries. Just last week, three-month bills were sold with a zero percent yield for the first time in history. That means buyers were willing to loan money to the U.S. at no charge.
Yields on the the benchmark 10-year note, currently at about 2.05 percent, are still lower than they were a year ago.
Jonathan Rick, a New York-based derivatives analyst at Credit Agricole CIB, warns that investors are being too complacent, which may leave them unprepared for sudden, sharp swings when U.S. interest rates do rise. Options traders still aren’t bracing for any sustained uptick in near-term Treasury volatility and are instead exposing themselves to even more risk.
The spikes in volatility have tended to “die away very quickly,” said Rick. But, “you are having thousand-year events more often.”
Whatever the outcome, most expect that the ultra-fast, computer-driven trading in Treasuries will only become more prevalent. That suggests investors in the world’s haven asset will need to get used to a choppier market.
“People are going for price, they are going for convenience and speed, and that’s what electronic trading provides,” said David Ader, the head of rates strategy at CRT Capital Group LLC. “It’s probably there to stay.”
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