Financial markets certainly have been volatile in recent weeks, driven largely by a sharp upward move in global bond yields. Investors are left searching for answers for the key drivers of the move in interest rates, as it was largely unanticipated and affected many portfolios. There are likely four intertemporal drivers of bond markets in recent weeks.
First, investors should recall that central banks can suppress but not eliminate volatility. Easing policy, bond purchase programs, forward guidance and negative deposit rates can be an important force in reducing term premium by managing market expectations for future interest rates, but market forces can – and will – respond to fundamental developments and valuation. In the recent case of 10-year German Bund yields, for example, they fell to a low of 0.07% while European economic activity was improving and inflation expectations were increasing. Eventually the fundamentals will be reflected in pricing. Indeed, market-based European inflation expectations for the next five years rose from a low of only 0.4% in early January to 1.2% in April. Exceptionally low interest rates and compressed term premium are inherently unstable.
Second, liquidity conditions have become even more constrained. Many have speculated about what caused the flash crash in U.S. Treasury bond yields last October. And now there will be speculation about the market dynamics pushing the flash spike in German Bunds. Earlier this month, 30-year Bund yields rose by 20 basis points in the morning only to reverse dramatically and close lower in yield by a few basis points. There was very little fundamental information that could have caused a multiple standard deviation move over the course of only a few hours. Increasing intraday volatility is likely to be a hallmark of the coming environment. Regulatory forces have brought about seismic shifts in market structure where former liquidity providers are either forced to the sideline or required to have a much shorter time horizon when transacting.
Third, with every day that passes, the Federal Reserve is getting closer and closer to liftoff. The first tightening of policy in nine years (with the past six years spent near the zero bound) will likely induce additional volatility in financial markets. Interestingly, there have been several Federal Reserve speakers in recent weeks adding a cautious voice to this topic.
Finally, there are a growing number of market participants and investment products that invest in a manner linked to market momentum. When market trends reverse, if a number of such strategies move in tandem, they could contribute to the extent or duration of such momentum.
After significant moves like those we experienced over the course of the last few weeks, markets are likely to calm down and consolidate for a period, but we should continue to experience heightened levels of volatility for the balance of the year as these forces continue to play out.