Punch-drunk bond investors drive wild market swings
Spare a thought for the bond traders.
The war in Iran has repeatedly wrongfooted government bond markets in recent weeks, triggering wild swings in this crucial corner of finance as investors grapple with the economic fallout from what threatens to be the most severe energy price shock in history.
Two-year Gilt yields this month registered their two biggest intraday moves since the collapse of Silicon Valley Bank in 2023, according to LSEG data, as they have soared more than 100bp.
The stomach-churning price action underscores how investors have struggled to adjust to fast-moving events in the Middle East and their implications for fiscal and monetary policy across the global economy. Many have responded by dialling back risk considerably as they await clarity on how the conflict evolves.
“This is very acute compared to previous periods of volatility,” said Tom Prickett, head of G10 rates trading for EMEA at Citigroup. “We’ve had a sharp escalation in a short space of time, both from a geopolitical and a markets point of view, and the ultimate destination is less clear than in previous periods of volatility.
"Whether it escalates further or reaches some new equilibrium has been an open question. That means that the magnitude of the moves and the level of volatility is still high."
Short-dated government bonds, because of their sensitivity to changes in central bank policy, have come under intense pressure since the US and Israel began bombing Iran in late February. Many investors had started the year betting that central banks were poised to lower interest rates, leaving them vulnerable to a surge in bond yields when energy prices jumped after the war erupted.
The second leg of the selloff came in mid-March when the Bank of England and the European Central Bank dashed expectations that they might treat any energy-driven rise in inflation as temporary and instead signalled they could raise interest rates to contain it. Two-year UK yields registered their biggest two-day jump since the aftermath of the September 2022 "mini-budget" Gilt market crisis, LSEG data show.
On Monday, a dramatic about-turn from US president Donald Trump sparked another day of whipsawing price action. Trump’s threat to bomb Iranian energy infrastructure sent yields spiralling higher early in the day, only for them to drop like a stone after he announced the US was in talks with Iran to end the month-long war. Bonds have remained volatile ever since as investors digest conflicting messages from Washington and Tehran.
“It has been difficult for investors to trade around this conflict,” said Andrew Sheets, global head of fixed income research at Morgan Stanley. “A lot of the positioning was offside for this type of event. It happened quickly and the price reactions have been difficult from a risk management perspective.
“The surprises have come in multiple stages. Investors stopping out of positions have definitely played a role [in the severity of the market moves]."
Opportunity knocks
Matthew Amis, investment director at Aberdeen, said his team dialled down some risk at the start of the war and has since been “quite defensive”. However, the investment manager has also looked for opportunities as bond yields have risen sharply.
“Things have moved in rates markets because there's been lots of painful stops,” he said. “You can see it across a number of markets and dislocations in various prices. For us, it’s an opportunity.”
A prime example was Aberdeen buying Gilts following a sharp rise in yields after the Bank of England’s MPC meeting on March 19. The BoE’s rate-setting committee signalled it stood ready to tighten policy to counter inflation, prompting a rapid recalibration from bond traders who had previously projected rate cuts from the central bank this year.
“Even if this oil price stays at US$100 and natural gas stays where it is, will the Bank of England hike four times this year [as market prices implied]?" said Amis. “That was more of a function of the market dynamics and stop-outs. So that’s why we were comfortable taking a position in Gilts.”
Fundamental drivers
Prickett agreed “there has been a liquidation element” to the magnitude of the moves in the front end of rates curves. However, he said energy and inflation expectations have also been “a large fundamental driver” causing yields to settle at structurally higher levels. The two-year Gilt yield was at 4.60% on Friday, up from 3.50% before the war began.
In particular, investors have been baking into prices the twin effects of central banks recognising the potential need to respond to an inflationary shock along with governments considering fiscal stimulus to cushion the blow for households.
Overall, many traders and investors remain cautious given the considerable uncertainty over what comes next – and are keeping risk levels in check in the meantime.
“When the market moves into a period of liquidation and risk reduction, then it becomes more important as a market-maker to be lighter in risk to be able to continue showing competitive prices,” said Prickett. “So, generally, we look to reduce risk when markets turn into this kind of volatile phase so we can facilitate the flows our clients need.”
