European bond markets have been shaken this year in ways few imagined

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(Bloomberg) – For European bond traders, 2022 was the year the playbook that has served them so well over the past decade was shattered.

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German and UK 10-year yields saw their biggest annual increases on record as sovereign bond markets were whipped by runaway inflation and uncertainty over how policymakers would react.

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In a rare event that marked a break from the era of negative interest rates and quantitative easing, eurozone implied rate volatility exceeded that of the United States, while transaction costs on the main European sovereign bond markets surged.

The upheaval is underway. Inflation is still far from being stifled and the European Central Bank and the Bank of England are expected to raise rates further, adding to the 250 basis points and 325 basis points of tightening already achieved this year respectively.

Meanwhile, the consequences of the protracted war in Ukraine – and what it means for Europe’s energy security – as well as the imminent end of Covid-19 restrictions in China will add further uncertainty for the markets of the region.

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Here are some of the major upheavals that have rocked the markets this year:

Rise in volatility

Euro rate volatility as implied by swaptions has exceeded its US equivalent at some maturities this year, a major shift in market dynamics. Until recently, price swings in eurozone bond markets were notoriously low due to ECB quantitative easing and sub-zero interest rates.

This is partly explained by the uncertainty about the evolution of interest rates. Inflation in Europe is largely driven by energy prices, which makes it more difficult for investors and policymakers to predict.

Rash spread

The lack of clarity on inflation and the path to tightening led traders to pile into highly liquid cash-like assets, such as short-term German government bonds. Meanwhile, swap rates were boosted higher as demand for hedging against rising borrowing costs increased. The spread between short-term bond yields and swap rates hit a record high in September.

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Authorities stepped in to help alleviate an anomaly that caught many traders off guard.

The ECB has suspended its 0% cap on certain deposits held with eurozone central banks until the end of April 2023 to prevent an influx of public liquidity into money markets. Steps taken by the German debt agency and the ECB to increase the supply of paper available to lend in repo markets, and positioning for a wave of new issuance in 2023, also helped ease the pressure.

Basic trade

Historic movements in yields in the Eurozone and UK bond markets have also wreaked havoc on bond traders whose hedging strategies have been turned upside down.

During periods of low volatility, determining which bond is the cheapest to deliver for a given futures contract is easy and does not change. However, this year, violent moves have distorted yield curves and caught traders off guard as these stocks unexpectedly shifted.

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In the gilt market, swings have become so disruptive that Tradition brokers have said the future of March gilt is the hardest to gauge since the contract was introduced in 1982.

Expensive liquidity

It has also become more expensive to place trades, according to a Tradeweb liquidity cost gauge. The firm compares the prices at which trades are actually executed with the composite price, or the price of a “representative sample of liquidity providers”.

In the case of the UK gilt market, these costs even exceeded March 2020 levels for some maturities following the poorly received spending plans of former UK Prime Minister Liz Truss.