Uddrag fra Zerohedge:
Yet while JPM is – as always – complacent about bond market risks, the bank concedes that “this does indicate that relative value trades which traded like short volatility positions have been unwound in recent days” and nowhere is this more evident in the 20-year sector of the Treasury curve, as 20s/30s flattened 4bp this week amid the broader long end flattening, moving into inverted territory
This violent shift in the 20s30s yield curve is merely the latest confirmation that liquidity across the curve is collapsing; here is Srini Ramaswamy from JPM’s rates derivatives team explaining why:
It was a wild ride in markets this week, with front end yields decoupling from longer maturity sectors of the curve. At the very front end of the curve, the drumbeat of rising inflation concerns continued to pressure front end yields higher and money-market sector yield curves steeper. Long end yields on the other hand, fell sharply this week. As the week came to a close, yields were higher by 4bp in the 2-year sector, but lower by 10bp and 15bp, respectively, in the 10- and 30-year sectors of the curve.
These sharp idiosyncratic moves are a clear sign of thin liquidity in markets, even as major thematic shifts are underway. Exhibit 2 shows, for instance, daily changes in the 10s/20s/30s swap spread butterfly over the past 5 years, with the bands representing a 2.2bp move (the size of Thursdays move) in either direction.
As can be seen, moves this large are very unusual outside of the March 2020 immediate aftermath of COVID-19, such a large move has only happened three other times in the past 5 years Oct 2nd 2017, Aug 19th 2020 and Feb 25th 2021. When individual issues in the Treasury market become dislocated from the Treasury curve, it generally represents periods of thin liquidity.
Even assuming JPM’s optimistic take is accurate what happens next? As the bank’s rate derivatives analysts concludes, “liquidity driven dislocations should ultimately fade, but could linger for a few weeks. One way to see this is to look at the performance of short gamma positions after periods of poor liquidity. Exhibit 3 shows the performance of delta-hedged short 6Mx10Y straddles in the weeks following periods of poor illiquidity (identified as periods when the 10s/20s/30s swap spread butterfly changed in magnitude by 2.2bp or more in a day). As can be seen, history suggests that the first few weeks following such episodes could stay volatile.”
Putting it all together:
- The liquidity in what is supposed to be the deepest, most liquid market in the world, is collapsing.
- In a time when the Fed is still injecting $120BN in liquidity every month, we just observed an event that has only happened on prior previous occasions – Oct 2nd 2017, Aug 19th 2020 and Feb 25th 2021. One can only imagine what happens to liquidity when the Fed begins to taper.
- As liquidity evaporates, rate vol is accelerating and dislocations across the yield curve accelerate, with bond vol surging while equity vol is completely ignoring the turmoil in the bond market. Eventually equity vol catches up to rates.
- Some extremely levered multistrat hedge funds are reprising LTCM and piling into treasury/futures basis trades – the same trades that blew up spectacularly in Sept 2019 and March 2020.
- As hedge funds pile into new flattener basis trades, others are liquidating basis steepeners, in some cases at huge margin call inducing losses, which force them to liquidate other performing assets.
- A positive feedback loop emerges as liquidity shrinks further while volatility rises as the basis trade funnel gets wider, and more enter while those hoping to exit hold off until the last moment.
- We hit a tipping point where all basis trades are no longer viable as there is simply not enough liquidity to put new trades on. That’s the moment everyone starts rushing for the exits, and as Sept 2019 and March 2020 showed us, that’s precisely the catalyst for a cross-asset crash, as basis trading funds scramble to boost liquidity while repo markets lock up. The result is a surge in volatility in underlying assets (TSYs), but also a freeze in the funding pathways (i.e. repo) that are used by the funds to fund said trades.
- Eventually, Fed steps in to bail out some of the world’s richest hedge fund managers, usually under the guise of some social calamity, like – for example – a viral pandemic.
