Central banks rule in the age of the flash crash

There has been a fundamental change in government bond markets. This has been apparent since the financial crisis in 2007/08 and the advent of quantitative easing.

But in the past two weeks, this transformation now looks to have moved a stage further, with violent swings in yields in German Bunds, hitherto one of the steadiest markets in the world.

German 10-year Bund yields, which have an inverse relationship with prices, have risen about 600 per cent since April 17, when the market touched a low of 5 basis points, or 0.05 per cent.

On April 29, German 10-year yields rose a staggering 75 per cent, one of the biggest daily moves in the market since the launch of the euro in January 1999. On Monday last week, yields jumped 21 per cent.

In the past two weeks, realised volatility in 10-year German yields has been 7.5 basis points per day compared with 2.9 basis points per day in the past six months.

In comparison, high-yield bonds, the supposedly risky and racy end of the market that more typically suffers from volatility, have been much steadier.

In essence, the old rules appear to have been ripped up as the world of bonds has been turned on its head.

Clearly, quantitative easing has a lot to answer for.

In the first place, did the economic environment justify a fall in Bund yields to 5bp, a level that suggests extreme disinflation pressures? Probably not. The only reason the market dropped so low was because markets do not like fighting central banks.

With the European Central Bank committed to buying more than €1tn of bonds, many investors, therefore, went along for the ride too, driving down yields. The rebound to more than 50bp looks like a more sensible level.

But there other reasons for the volatility, which are more worrying and suggest that we are now in the age of the flash crash, whether it is a plunge in yields like last October's freefall in US Treasuries or a plunge in prices like Bunds in the past two weeks.

First, the banks are no longer there to buy when prices are falling or sell when prices are rising in their former market-making role, whereby they helped set prices and broadly acted as a stabilising force.

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Without the banks as market makers, an essential anchor has been lost.

There is also less liquidity as, without the banks, there are fewer participants. This means that just a handful of trades can cause sharp swings in the market. Some investors say the big moves in Bunds were caused by a few transactions in low volumes.

Second, computer-driven trading is more prevalent today. When one trader living in west London can apparently cause a 600 point plunge and then rebound in the US stock market in the space of 20 minutes, as has been alleged in court this year, then it does make you wonder whether so-called algorithmic trading might be responsible for some sharp swings in other markets too.

Finally, and perhaps most important of all, further volatility might be caused or exacerbated by a change in perception of Bunds as a safe market.

Whether it is because of Greece and worries over the eurozone or the loss of the banks as market makers, concerns over volatility in itself may cause investors to become more panicky and more likely to hit the exits at the first hint of trouble.

Bunds may not have default risk like high-yield bonds, but they most certainly have volatility risk. As a consequence, the old and predictable world of government bonds may have changed for good.

David Oakley is the FT's investment correspondent

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