Intervention becomes standard procedure in bond markets

Extraordinary intervention becomes standard procedure in bond markets

Where once the bond markets were considered somewhat immune to the vagaries of the wider financial markets and the volatility of the global economy, in recent years, the story has been very different.

Now not only does the bond market move in response to times of stress and volatility, it even responds to the regular cycles of the market, such as year-end and quarterly reporting cycles, according to a new report from the International Capital Market Association (ICMA)^[1].

Last year, in response to a request from its members, the ICMA created the Bond Market Liquidity Taskforce (BMLT) to look into the microstructures of the bond market and its liquidity conditions in a bid to provide recommendations to improve resilience. Its first report is focused on core European sovereign bond markets: Germany, France, Italy, Spain, and the UK.

Although the association found that liquidity is generally good, and larger than average transactions can be executed relatively quickly, without significantly moving the market, it also found that the markets were more cyclical.

“This can be roundly attributed to the combination of a significant increase in the outstanding stock of government debt while primary dealer balance sheets and appetite for risk, on aggregate, have reduced markedly,” the report said.^[2]

“Applying modelling on historical bid-ask spreads, it becomes clear that at certain points these widen significantly, and this cannot be explained by volatility alone. Rather, volatility is the catalyst for a discernible retreat from liquidity provision.

“Furthermore, the speed at which markets become volatile (the ‘volatility of volatility’) has increased, possibly aided by greater transparency and more dependence on e-trading and automation.”

Intervention is the new normal

Perhaps most interestingly, the ICMA found in talking to market participants that they believed central banks have a key role to play in offsetting this volatility.

“Market participants accept that episodic heightened volatility, with rapid evaporation of liquidity, and a sharp repricing of risk, is the new normal. Participants also believe that central banks will be required to intervene in bond markets more frequently and systematically to restore stability,” the report said.

Robin Wigglesworth at the Financial Times has pointed out that the focal point of financial crises used to be the banks, but that central banks may need to wade into the markets much more in a financial system where nontraditional financial systems are gaining in importance.^[3]

This chimes with comments from Dave Ramsden, Deputy Governor of Markets and Banking at the Bank of England,^[4] who echoed the Governor of the Bank of England Andrew Bailey’s comments that a larger central bank balance sheet would be needed to meet the financial system’s demand for reserves and liquidity buffers.

“The Bank will, therefore, not shrink its balance sheet to the level it was pre-GFC (global financial crisis). At the moment we do not know precisely where the new normal level of reserves will be, or what the composition of the assets backing those reserves will be,” he said.

“The Bank is committed to providing sufficient reserves to meet its monetary policy and financial stability goals, and expects its facilities, both existing ones and those required by the circumstances of the time, to be used at scale to meet the demand for reserves.”

Returning to the ICMA report, participants said they believed they were in a new era for sovereign bond markets, more subject to events triggering volatility and illiquidity.

“The unwind of central bank asset purchases, while ultimately healthy for liquidity more broadly, will likely add to volatility and market sensitivity in the near term. This will also increase overall supply, while dealer balance sheets are set to become even more constrained with the roll-out of Basel 3.5, which may also see a retreat of some traditional liquidity providers,” the report said.

“All of this makes central bank interventions to stabilise markets increasingly inevitable and less extraordinary.”

Volatility and opportunity

For OTC market participants, volatility can mean opportunity as well as challenge, provided they have the right information at the right time. Analysing the response to past events such as the 2008 global financial crisis and looking ahead to potential scenarios can inform current risk management strategies.

Parameta Solutions, the data and analytics division of TP ICAP Group which is the world’s largest inter-broker dealer, has unrivalled indicative and transactional data which comes with full history for all the markets we cover. Our depth of coverage supports clients with generating alpha, price discovery, risk management and valuation tasks so they can meet regulatory and compliance requirements.

^[1]https://www.icmagroup.org/assets/ICMA_BMLT_Liquidity-and-resilience-in-the-core-European-sovereign-bond-markets_March-2024.pdf ^[2]https://www.icmagroup.org/assets/ICMA_BMLT_Liquidity-and-resilience-in-the-core-European-sovereign-bond-markets_March-2024.pdf ^[3]https://www.ft.com/content/c289d5f4-477e-478b-9179-55c5e45a8b46 ^[4]https://www.bankofengland.co.uk/speech/2024/february/david-ramsden-keynote-address-at-association-for-financial-markets-forum

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