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There’s a lot more than just this but here’s some highlights:
- For a two-week period in mid-March 2020, government bond markets experienced uncharacteristic turbulence, sometimes selling off sharply in risk-off episodes when they would normally attract safe haven flows
- Orderly markets rest on buyers who are attracted by low prices to enter the market, so that price declines in the absence of fundamental news are cushioned by purchases. However, from time to time, the demand response can become perverse, where price declines may beget more sales. One example is when an investor has borrowed money to purchase assets. When the asset price falls and threatens the investor’s solvency, the lender will call in the loan, forcing the investor to sell. In this way, a price decline can lead to further sales, not purchases. Without dealers who can absorb sales and stabilise prices, a feedback loop may develop where price declines beget more sales, leading to further price declines
- Unwinding of hedge funds’ relative value strategies. As volatility picked up and margins surged, particularly at the long-end (Graph 2, right-hand panel), liquidity in futures markets deteriorated sharply (Graph 3, left-hand panel). Futures-implied yields dropped more rapidly than bond yields, imposing mark-to-market losses on relative value investors who had sold futures and bought cash bonds. One facet of the ensuing price dislocations between bonds and futures was the fact that the implied repo rates of the cheapest-to-deliver bonds in the futures contracts rose markedly above market term repo rates (Graph 3, centre panel). In frictionless markets, the implied repo rate that an investor would earn by buying the cash bond and delivering it in fulfilment of the futures contract should theoretically be equal to the actual term repo rate. The breakdown of the relationship suggests severe strains at the time in relative value trades. Once the funds were no longer able to meet variation margins, their positions were unwound by dealers/futures exchanges, pushing prices lower. This in turn gave rise to a classic “margin spiral” (à la Brunnermeier and Pedersen (2009)), whereby the cycle of illiquidity, price dislocations and tighter margin requirements fed on itself
- Dealer balance sheets under pressure. Under normal circumstances, dealers would be able to alleviate market stresses by absorbing sales and building up an inventory of securities. But, dealers’ treasury inventories had already been stretched, especially from 2018 onwards, as they needed to absorb a large amount of issuance. With inventories already bloated, dealers faced severe difficulties of further absorbing the unwinding of investor positions in March 2020, particularly at the long end
- Knock-on effects on systematic funds. While the locus of initial market turbulence largely involved relative value investors, de-risking quickly spread to systematic funds, …. including so-called CTA/momentum funds, volatility control funds, risk parity funds. During the Covid-19 crisis, the dislocation in the treasury market meant that bonds no longer performed as a hedge or delivered desired exposure in either type of strategy. As the funds scaled down leverage, this led to a dash for cash, exacerbating declines in both equity and bond prices
- More generally, there are important lessons on the importance of the composition of the investor base, and the related policy issue of the provision of liquidity by central banks. Given the importance of the government bond market as a benchmark financial market price, any dysfunction has far-reaching detrimental effects that ripple through the rest of the financial system and the real economy.
- Recent events also illustrate how the authorities may need to absorb sales directly rather than doing so indirectly by lending to dealers, especially when funding is not the relevant constraint. This may also explain why, on this occasion, the Fed’s rapid purchases of securities out of dealers’ inventories (to the tune of about $670 billion) appeared more effective in stabilising the market than the provision of liquidity via repo operations, where take-up was relatively subdued.