What Really Happened in the US Government Bond Market on the Morning of October 15th?
What happened in the US government bond market on the morning of October 15th? We have been hearing veteran bond traders say that they had never seen anything like it and that the bond market doesn’t work that way. Did the US Treasury market, arguably the most liquid market in the world, experience a Flash Crash (or actually a Flash Dash since prices rose and yields fell)?
The NY Times wrote an excellent article yesterday chronicling the events of last Wednesday:
“After the Treasury market opened, the yield on the 10-year Treasury, which moves in the opposite direction of its price, plunged far below the 2.2 percent that it had closed at the day before. By 9:36 a.m. on Wednesday, it hit 1.9 percent. Then it snapped right back, and within 15 minutes, was again trading above 2 percent.“
“Most analysts agree that there was not enough bad news on Wednesday to explain the trading in the 10-year Treasury. “It was definitely not all fundamentals,” Shyam S. Rajan, a rates strategist at Banc of America Merrill Lynch, said.”
Take a look at this chart from Nanex which shows the evaporation of liquidity on the 10 year note. The top half of the chart is the price of the 10 year bond and the bottom half of the chart is the depth of orders. Look at liquidity start to disappear at 9:33am and then almost completely disappear around 9:40am. This is not a small cap stock, it is the US Treasury 10 year note!!
So what happened?
Apparently, there was a rumor in the market that a hedge fund with a very large short bond position was covering. But in a dealer driven market, in the most liquid instrument in the world, this event should not have caused the spike that occurred. We can’t help but see the striking similarities between the bond market flash dash and the US stock market flash crash from May 6, 2010.
Initially, the stock market flash crash was blamed on a large order in the e-Mini futures contract placed by a mutual fund. But after careful analysis by the Joint SEC-CFTC Advisory Committee , the flash crash was proven to be caused by the “hot potato” trading between HFT firms and the eventual exiting of their “normal” liquidity. Market orders that normally were intercepted by internalizing brokers got shipped out to exchanges and searched for bids that were quickly dropping. In their recommendations, the Joint SEC-CFTC Advisory Committee wrote these words:
“Indeed, even in the absence of extraordinary market events, limit order books can quickly empty and prices can crash simply due to the speed and numbers of orders flowing into the market and due to the ability to instantly cancel orders.”
Sure seems like this is what happened in the bond market on October 15th. But doesn’t the bond market have dealers that commit capital to absorb liquidity shocks?
While we are not bond market experts, we have been keeping tabs on them and it is readily apparent that traditional dealers have been exiting the business, particularly in the corporate bond market. Firms like Blackrock have noticed this and have been warning that the corporate bond market structure is “broken” and a liquidity event can occur at any moment. Just yesterday, Nathaniel Popper of the NY Times wrote an article about how JP Morgan has embraced the automated market maker model in fixed income department:
“The face of automation on Wall Street is a computer hooked up to nine blinking screens that goes by the name Quantitative Market Maker, or Q.M.M. Now, Q.M.M., which sits on the same floor as those traders in a Midtown Manhattan skyscraper, can come up with the same prices in a fraction of a second. When it completes a trade, it emits a jingling cash register sound, making the trading floor sound like an arcade.”
The bond market appears to have fundamentally changed and no longer seems to have the built-in liquidity shock absorbers provided by traditional dealers. Some will say that Dodd-Frank caused this since dealers can no longer hold as much inventory. Some will say that this is just the natural evolution of electronic trading. But something is wrong when the safest bonds in the world experience such a rapid price move in such a short time period. Unfortunately, we say to our bond market friends, welcome to our world!