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In Brutal Year for Bonds, Trading Has Become Exciting Again

·7 min read

(Bloomberg) -- Amid the wreckage of the great bond-market bust of 2022, there is a silver lining for some: Traders in the trenches of the $24 trillion Treasury market say it’s finally exciting again.

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This turn of events follows years of markets being lulled to sleep by central bankers doing whatever it took to suppress interest rates, in part to -- get this -- keep inflation from falling too low. While the excitement may not rival the likes of crypto or meme stocks, it’s enough to make trading government debt a lot more interesting. This year, with the Federal Reserve and global policy makers aggressively lifting rates to rein in consumer prices, many fixed-income professionals have been confronted with the wildest volatility of their careers.

Of course in finance, the levels of excitement is usually tightly correlated with the amount of money being made. So it’s no surprise the two are rising in tandem. Trading revenues have boomed for the major US banks with a strong presence in US rates markets. At Citadel Securities, an important provider of prices in the Treasury market, this year’s turbulence led to a record $4.2 billion in first-half net trading revenue.

“We are right in the sweet spot of rates really being an interesting market, with clients being excited to trade,” said Paul Hamill, head of global fixed income, currencies and commodities distribution at Citadel Securities. “Everyone is spending all day talking to clients and talking to each other. It’s been fun.”

After a decade of well-telegraphed central bank messaging that largely kept a lid on market volatility, the biggest inflation shock since the 1980s has compelled monetary authorities to abandon modest quarter-point rate hikes. Both the US Federal Reserve and European Central Bank have deployed three-quarter-point moves and the Bank of Canada in July went one better with a hike of one full percentage point. Sweden’s Riksbank’s on Tuesday also increased its policy rate by a full percentage point.

Traders widely expect the Fed to bump rates up by another 75 basis points on Wednesday, marking the third straight move of that magnitude. There are several other central banks meeting this week, set to spark more trading activity globally. Money markets now see about a 60% chance that the Bank of England pushes rates up by 75 basis points on Thursday. Rate increases also are expected this week from the central banks of Indonesia, Norway and Switzerland, among others.

Read more: Bears Zero In on Three Key Trade Ideas Before Fed: MLIV Pulse

With little respite from hawkish monetary policy in the near term, bond markets remain volatile, characterized by sudden and sweeping daily swings that are typically a favorable environment for traders and dealers.

The Fed’s fastest pace of tightening in a generation already has the two-year US Treasury yield poised to climb above 4% for the first time since 2007. The rate on the 10-year US note was up 7 basis points to 3.56% on Tuesday, its highest level since 2011.

‘Running Out of Havens’

“This will be a defining week for Fed rate expectations between now and the end of the year,” said Ian Lyngen, head of US rates strategy at BMO Capital Markets. Ahead of the Fed decision, the selloff in Treasuries on Tuesday was led by the 10-year in terms of yield rise and volume, he said, reflecting a sense of investors “not wanting to be long the market. As we shift to a truly aggressive monetary policy stance, investors are running out of havens.”

Of course, the excitement for bond traders belies the pain the macro environment and market action is causing for many. Persistent high inflation and surging interest rates have catapulted costs higher for everything from food to gas to mortgages, while brutalizing 401(k)s and other investment accounts. Fed Chair Jerome Powell himself said last month that his campaign to rein in prices “will bring some pain to households and businesses.”

The Fed is also reducing its balance sheet at a faster pace than during its previous tightening cycle that ended in 2019. The central bank’s retreat means the loss of a whale of a bond buyer, one that anchored yields and limited a more natural two-way market.

“For many, many years, even with TIPS for example, you were just getting crushed as the Fed was just buying them,” said Vineer Bhansali, the founder of LongTail Alpha LLC, referring to Treasury Inflation-Protected Securities. “To be really honest, it’s just a lot of fun now to trade bonds again. It’s like very old school again, trying to figure out where things are breaking and relative-value arbitrage. Classic stuff is working now. Momentum is working, vol trades are working, spread trades are working.”

Bhansali contends the modern bond market built on computer trading models is struggling in this new climate, characterized by the fastest pace of US inflation since Ronald Reagan was president. “The best part of it is that all the machine-learning, data-science wonks have absolutely no idea now because their data does not go back to the 1990s – where there actually was no real data. So a lot of the stuff that they know has made them just get whipsawed around.”

Avoiding the dreaded tap on the shoulder from a risk manager means a willingness to shift your trading style in the current bond market.

‘Tremendous Opportunities’

“Inflation and the current macro environment has changed past relationships, from correlations to traditional risk-rewards trades,” said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group. “People don’t like change. And when the market environment changes, it takes a while for people to realize this stuff is not going to work. That provides tremendous opportunities for people that like to try something different or be a little more tactical over time.”

Even for bond managers with decades of experience, the speed of rate swings this year has been extraordinary. “We saw the Agg rally 2.4% in July and then decline 2.8% in August, and these are the sort of monthly changes that are more typical of what you see in a year,” said Rick Rieder, chief investment officer of global fixed income at BlackRock, referencing recent swings in the Bloomberg US Aggregate index that many bond funds use as a benchmark. “Liquidity is not great and people do overreact and we have found that fading the news of the day has been a good trading strategy. You need to stay patient, have a plan and execute when the market gives you an opportunity.”

One aspect of market volatility that’s unwelcome among many traders is how sudden and big the daily swings have been, a factor that only impedes liquidity further.

‘Trade Like Tourists’

“The ratio of the intra-day volatility, and randomness of it, relative to what you expect for rates over the medium to long term is really far off,” said Paul Murphy, head of US rates trading at Amherst Pierpont. “It forces people to trade like tourists in the market, with few committing capital. That means there’s nobody to countertrend the intra-day spikes. And that’s spooking people in terms of liquidity.”

Still, many reckon the current dynamic of trading in Treasuries is not going away any time soon. For some, that’s an appealing outlook -- so long as you can stay on the right side of big market swings.

“I think it’s going to be a great time over the next six months,” said Bhansali, “if you don’t get caught on the wrong side of a position.”

(Updates with details on global central bank meetings and market moves starting in fifth paragraph.)

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