Low liquidity = risk of high volatility, if not of manipulation

The simplest way to check the stability (or lack of thereof) of market expectations, is to break down bond yields into two components: the ‘risk free rate’ and the term premium

Since mid-April, financial markets have gone through a significant re-pricing of key assets such as German Bunds but also US Treasuries, crude oil and €/$. While the modest rise in US long term interest rates as well as of the price of crude oil can be reasonably related to fundamentals, the same cannot be said of the violent rout that pushed the German 10Y yield from 0.08% (20 April) to 0.6% (7 May). Neither is justified the appreciation of the euro (from 1.06 to 1.14 over the same period), in my view. As for Bunds, the Bundesbank and the ECB will continue to buy steadily every single week and, if, in May, the net supply of Bunds should slightly exceed PSPP purchases, this will be the exception. Unless banks and insurers suddenly decided to sell their assets –which they won’t do for well documented regulatory reasons- the scarcity of German paper will strike again, especially in June and July.

Therefore, we are likely to see the tide reverse in these two markets: Bund and euro/dollar in the coming months, since the yield differential between Germany and the US is a key driver of the exchange rate. Yet, the early May episode should remain in the market memory as a vivid illustration that in a situation of thin liquidity, volatility may be very high. Notice how different are the consequences of QE in the US and in the euro area, in this regard: while in the US, steady and predictable liquidity injections by the Fed reduced volatility, the opposite holds in the euro area, because of the strings attached to the purchase program (PSPP): respecting the capital key of the ECB in order to avoid being accused of deficit financing, ceilings on pool of purchased securities (the 25% and 33% rules) in order to avoid being accused of distorting the markets, market action delegated to national Central Banks and so on. The truth is, given the peculiarity of the euro, a monetary union without fiscal union, the ECB cannot but implement a second best in terms of quantitative policy. Still, the sharp acceleration of money supply (M3 3M/3M annualised rate at 9.2%) and the unthawing of loans to the corporate sector, which flows have turned positive for the first time since 2010, are vindicating the ECB’s policy and leave little doubt on its sustainability and durability. Didn’t Mario Draghi said that this was the beginning of a marathon, not a sprint?

Back to the Bund market rout, our statistical analysis leaves little doubt about its origin: the rise in yields was not caused by changes in the assessment of economic conditions by the financial markets, neither on growth, nor on inflation, not even on the monetary policy reaction function, at least as far as the interest rate policy (as opposed to the balance sheet policy) is concerned. The simplest way to check the stability (or lack of thereof) of market expectations, is to break down bond yields into two components: the average of expected monetary policy rates (also named the ‘risk free rate’) and the term premium, a decomposition recently hailed by Ben Bernanke in his refreshing blog. The trick here is that market expectations cannot be simply derived from future markets, which are themselves biased by risk premia, a point made long ago by Milton Friedman himself. Separating the ‘risk free rate’ from the term premium requires a sophisticated statistical analysis, such as the one performed by Adrian, Crump and Moench of the Fed of NY (see Bernanke, op. cit) for US Treasuries. We have duplicated this analysis for other bond markets and here is what it is showing for the German bond market:

Source: Zhili Cao, AXA IM Research

While the risk free rate (the geometric average of 1Y rates over the next 10 years rose by less than 8 bps between April 20 and May 5, the term premium (the unexplained part of the 10Y yield) jumped by almost 40bps, testimony that the ‘sell-off’ was not driven by fundamentals but by the rapid build-up of short positions that are now unwinding, after having caused the unwinding of allegedly overcrowded long trades.

Even though the violence of the re-pricing of the euro sovereign markets is a sign of financial instability and therefore a potential cause for concern, it is also good news for long term investors which need to invest in safe and liquid assets, for prudential and regulatory reasons. These real investors were able to re-enter the sovereign markets, another good reason to expect euro area yields to resume their decline, going forward.

Eric Chaney – Chief Economist AXA Group & Head of Research AXA IM