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Good morning. The UK sovereign bond market is now so volatile that comments on it are hostage to fortune. By the time our US readers open this email, things may have changed completely. But Unhedged likes living on the edge. Email us: [email protected] and [email protected]
Here’s a chart:
UK 10-year inflation-linked gilt yields rose 64 basis points yesterday, hitting 1.24 per cent. This is an absolutely bonkers move. In price terms, the 10-year linker fell 5.5 per cent; developed world sovereign bonds are not supposed to move like that (the 30-year linker was down 16 per cent on the day).
At the same time, very strangely, nominal 10-year gilt yields rose by much less — 23bp. In a brief story, our friends at Bloomberg noted that the move in linkers was the largest since at least 1992, and said the move was driven by “concerns over market frailties ahead of the Bank of England ending its bond-buying operations”. That sweepy phrase seems to mean “we don’t really know what is going on here”. Unhedged sympathises; we don’t really know what is going on here, either. All we can offer are the following thoughts:
Economic fundamentals cannot explain this move. In a liquid and efficient market, index-linked bonds would be a proxy for the real rate of interest. The real rate of interest in the UK did not double yesterday. Also, in a liquid and efficient market, nominal bond yields minus inflation-linked bond yields is proxy for inflation expectations. Ten-year inflation expectations did not fall by 40bp yesterday.
This move is partly to do with liability driven investment strategies at pension funds. The very rapid rise in yields which followed the Liz Truss/Kwasi Kwarteng “mini” Budget announcement left LDI investors with big losses on their rate hedges, forcing them to sell gilts to raise cash. LDI investors own a lot of inflation-linked gilts, as well, and have been forced into selling them. But there is a crucial difference: the Bank of England is not buying inflation-linked gilts as part of its temporary market stabilisation programme. Given that the inflation-linked market is relatively thin to begin with, the presence of forced sellers in the absence of a buyer of last resort adds up to an ugly day.
While not as wild as the move in linkers, the move in vanilla gilts is a big deal, too. As the FT reported:
Monday’s fall in gilts came despite the BoE announcement earlier in the day of a new short-term funding facility to avoid a “cliff edge” when the central bank’s £65bn emergency bond-buying programme ends this week.
On a day when the UK government also sought to reassure markets by bringing forward the date of a debt-cutting plan, the 30-year gilt yield jumped 0.29 percentage points to 4.68 per cent. The gilt market has been unsettled since the government announced unfunded tax cuts last month.
The BoE announced yesterday that it was raising the upper limit of its daily purchases of long-dated bonds from £5bn to £10bn. It also announced a temporary repo facility “to enable banks to help ease liquidity pressures facing their client LDI funds”. The facility allows banks to borrow using a range of securities, including index-linked gilts, as collateral. The idea is that the banks will be able to act as intermediaries for LDI investors who need to raise cash. Neither move worked. As of Monday, the long end of the curve was clearly out of the BoE’s control.
We don’t yet know why the bank’s interventions have not worked (we’re trying to talk to more of the people involved). But there is something odd about the fact that, before yesterday, the bank had a cumulative purchase ceiling of £40bn, and had purchased only £5bn in bonds. Yesterday, it set a daily limit of £10bn and bought just £853mn — while bond prices were crashing. We don’t know the details yet, but from the outside, this sure looks like a halfhearted intervention, not so much yield curve control as politely asking the yield curve, if it wouldn’t mind terribly, to behave itself, just for a few days? Please?
Unhedged is still a little puzzled about how all of this got started and why it is all so bad. There was a simple narrative when the “mini” Budget was announced and the market recoiled. Fiscal deficits were going to rise. That meant the supply of gilts would increase, pushing their prices down. What’s more, the budget implied an odd combination of tight monetary and loose fiscal policy. This, along with some general clowning around with the budget process, meant that the extreme market moves could be explained by the loss of credibility, or, if you prefer, a widening risk premium on UK gilts. But the fact that much of the fiscal programme has now been rowed back, and the market is still not pacified, suggests there is more to this story. Part of this is the LDI funds puking bonds into the market. Part of it is the simple fact that the global policy tightening cycle impairs liquidity and risk appetites. But Unhedged suspects there is something more going on.
That something more may be international. Bund yields moved 15bp yesterday, too.
This story ain’t nearly over.
Put options panic
Record put option volumes have been getting a lot of play in the financial press, including here at Unhedged. We quoted this FT story two weeks back:
Investors are buying record amounts of insurance contracts to protect themselves from a sell-off that has already wiped trillions of dollars off the value of US stocks.
Purchases of put option contracts on stocks and exchange traded funds have surged, with big money managers spending $34.3bn on the options in the four weeks to September 23 . . . The total was the largest on record in data going back to 2009, and four times the average since the start of 2020. Institutional investors have spent $9.6bn in the past week alone.
A Bloomberg story, citing the same research, emphasised surging premium costs — seen as a measure of demand for downside protection:
Seasoned investors, staring at a world clouded by war, inflation and economic uncertainty, are buying catastrophe insurance at a record clip.
Institutional traders paid $8.1bn to initiate purchases of equity puts last week, the highest total premium in at least 22 years, Options Clearing Corporation data compiled by Sundial Capital Research show. Adjusted for market capitalisation, demand for hedges matches levels from the 2008 financial crisis.
The spree is the latest evidence of sky-high anxiety on Wall Street . . .
You can understand why this gets attention. It fits with a general vibe of fear and anxiety. Charts like this don’t exactly inspire confidence:
But one reader, who works in the derivatives business, warned against taking this data at face value. Higher put option volume doesn’t necessarily mean rising fear, he argued. There is no distinction in the data between those who buy put options as a bearish bet against stocks and those who are hedging a separate position. Plus, there’s an entire industry of options market-makers with a different set of incentives — trying to harvest the bid-ask spread while managing risk. In a higher-rate world, our reader argued, market makers could even be trading options to earn a bit of carry. Higher put volume is not proof of panic.
Put premiums also need to be understood in context. Nitin Saksena and Gonzalo Asis, derivatives analysts at Bank of America, compare the total premium that put buyers pay to hedge with the total premium received by put sellers (the two can be different because buyers and sellers often transact with market makers, rather than directly with each other). The difference in the two premiums is a proxy for supply-demand balance in puts. Hedging demand for puts is elevated, though not to any level suggesting panic, Saksena and Asis say.
Moreover, the “put skew” tells a different story. This is a measure of what investors will pay for protection against large equity drops relative to protection against smaller dips. The additional cost of insuring against big drops has been falling all year:
Saksena and Asis make the point that what really moves options markets is a rush-for-the-doors selling spree in equities. However, what we’ve seen this year has been more incremental, a long string of 2-3 per cent sell-offs, giving investors time to adjust. That may be the silver lining of a Federal Reserve tightening cycle that you could see from a mile away. (Ethan Wu)
One good read
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