Welcome outbreak of sanity for bonds

Was it technical or fundamental? Post-mortems on last week's flash crash in German Bunds and the wider jump in bond yields across the developed world have revealed no consensus on the precise cause of these extreme market contortions. And it has to be said that a combination of disappointing economic growth and rising bond yields takes some explaining since it usually requires stronger than expected growth to cause bond yields to soar.

In fact both technical and fundamental forces were at work. A big clue on the fundamental side can be found in early data on capital flows in April. While investors were dumping fixed-interest bonds, they were simultaneously pouring money into index-linked government IOUs. According to data provider EPFR, inflation-protected bond funds recorded their seventh straight weekly inflow - the longest such run since the first quarter of 2012.

In other words, against a background of surging energy prices, market psychology had shifted from the fear of deflation to the fear of renewed inflation, which in turn raises the possibility of earlier central bank interest rate increases than previously expected. Throw in mounting worries about Greece and the picture more or less makes sense. But if the rush to take out inflation protection has been going on for so long, why did fixed-interest paper wait such a while to fall out of bed?

That is where the technical factors come into play. Forced buying by insurance companies and pension funds under regulatory pressure, a shortage of liquidity following regulatory restraints on banks' market making and proprietary trading, the growth of passive investment vehicles that are de facto momentum traders, overcrowded speculative positions based on the assumption that overpriced bonds could be dumped on the European Central Bank - whichever of these explanations you prefer to emphasise there is no question that there are numerous short-term technical influences on markets that encourage overshooting.

There are also longer-term factors at work, most notably changes in the structure of demand. Among the most important is the decline of defined benefit occupational pension schemes underpinned by corporate sponsors. Immature pension funds, which are paying out less in pensions than they receive in contributions and investment income, have a huge capacity to absorb loss and to stabilise markets. They are habitual net buyers of securities and where they are big in relation to the overall financial system they can come to the rescue in a financial crisis.

The classic instance was the British secondary banking crisis of the mid-1970s when the banking system was overextended in property. Those pension funds and insurance companies that had large stakes in secondary banks were arm-twisted by the Bank of England into bailing out the banks. Others simply bought illiquid property at knock down prices, which took the banks off the hook. Pension funds that had themselves become overextended in property - the funds of Unilever, Imperial Chemical Industries and the Electricity Supply Industry were cases in point - found that because they were immature their rising cash flow shrank their property losses in relation to the size of the fund over time.

Heavy-handed regulation has now imposed shrinkage on defined benefit pensions. Much the same is happening in insurance. And the new masters of the investment universe such as managers of official reserves and corporate cash hoarders have an acute focus on liquidity. Even sovereign wealth funds, which in theory have a long-term focus, find that their government backers suddenly want their money back in economic crises.

At the same time the rise of bond mutual funds and exchange traded funds creates worries about more herd-like behaviour in markets, especially where there are mismatches between the liquidity they promise to yield-hungry investors and the liquidity in the underlying markets. The secondary market in corporate bonds, for example, has always been relatively illiquid and is even more so today when banks are reluctant to provide liquidity when investors panic.

This, then, is a world with a greater than usual bias towards overshooting. Since an estimated $1.7tn of bonds still shows a negative yield, more overshoots are in prospect. But be grateful for small mercies. While the absolute level of bond prices looks crazy, the bond market's signalling function is intact, albeit with an inbuilt delay. An all too modest outbreak of sanity is the way to think about last week's spike in yields.

The writer is an FT columnist

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