Via the excellent Damien Boey at Credit Suisse:
Overnight, the Fed announced it will be increasing its repo size to $1 trillion per week, while the ECB announced more liquidity management and asset purchase measures (refraining from cutting rates into more negative territory). Yet despite all of this massaging, bond yields rose into the close, and are rising in the Asian time zone. What has caused central bankers to behave the way they have? And why aren’t bond yields falling in response to the measures announced?
The issues are that volatility in the bond market is now at very high levels, and illiquidity is becoming a major problem. These factors are causing some highly perverse pricing distortions across the fixed income complex, and general upward pressure on bond yields, causing the Fed to consider stepping in. But there are question marks about whether the Fed’s balance sheet expansion is the right way to manage illiquidity in the system. Some commentators are suggesting more nuanced measures such as debt buybacks instead. Our issue is that risk parity investors are now pretty much all in on bonds, at just the wrong time, when bonds are experiencing the sharpest delta in risk profile of all the major asset classes. The concentration of risk is resulting from de-risking behaviour to date, while the increase in bond volatility is resulting from:
- Reflation risk from fiscal stimulus.
- The improving profile of expected returns in alternative asset classes to bonds, and the overvalued starting point for bonds.
- General illiquidity.
- The lingering effects of heightened oil price volatility on inflation expectations embedded in bonds.