Bond market fireworks flash warning signals

In Tom Wolfe's novel The Bonfire of the Vanities, the bond trader Sherman McCoy struggles to explain his job to his young daughter. Reporters trying to decipher the bond market know how he feels. Sharp bond price movements seldom arise from a single discernible cause, and untangling how they have behaved is often no easier than predicting what they will do next.

The past few weeks provide an excellent example. Since mid-April the yield on the German 10-year bond has soared from under 10bps to above 50bps, a correction matched in the markets for French, Italian and other European debt. A half percentage point rise in interest rates may not sound like much, but at such low yields the concomitant movement in bond prices becomes ever more violent. Any investor unlucky enough to have bought near the peak now sits on painful paper losses far outweighing what might be received in interest.

Not only investors with poor timing wonder at this change in sentiment. As well as using bond markets as a channel for quantitative easing, the European Central Bank pays close attention to their behaviour in order to understand how the medicine is working. But interpreting them is as much art as science: while the infusion of cash may depress interest rates in the short term, over a longer horizon it should lead to higher inflation, more borrowing and interest rates rising back to normal.

An optimistic onlooker might therefore discern evidence of QE working as intended. As bond yields have risen, oil and other commodities have rebounded from recent lows. There are also signs of eurozone activity picking up. From this rosier viewpoint, a few days of turmoil is belated punishment for some investors' excessive pessimism when chasing yields so low. Anyone buying bonds that yield so little is placing a bet on the eurozone remaining mired for years to come, despite the outpouring of trillions of euros. Rather than wondering at how the bund can now trade at 50bps, a better question is why investors ever allowed it to yield as little as 10bps

But it stretches optimism too far to see such abrupt market movements purely in terms of QE working as it should. Effective monetary stimulus ought to boost equity prices and weaken the currency, but shares in Europe have subsided in recent weeks, and the euro has strengthened. Above all, if monetary stimulus explains the rise in bond yields, it is difficult to see why markets realised it so late and so suddenly. Mario Draghi, president of the ECB, prepared the ground over many months. When QE finally arrived, few should have been surprised. There was nothing about how it was delivered that justifies the schizophrenic gyrations of the past few weeks.

A more worrying explanation is that bond markets no longer have the capacity to behave rationally, adding to the evidence of last autumn's "flash crash" in US treasury yields. Some investment bankers put this down to regulations that sap their ability to make a liquid market. Another explanation is that herd mentality becomes worse when yields are low - the upside is small, while the potential losses anything but. In such circumstances, the rush for the exits can be chaotic.

Bill Gross, the legendary (non-fictional) bond trader, has recently called the end of the 35-year bull market in government debt. Just as it took the action of determined central bankers to bring to a close the era of high inflation, they do have the tools to lift bond yields off the floor and keep them elevated. Despite the fireworks that may follow, it is surely better the shift happens sooner rather than later.

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