Bond Risk on and Bond Risk off!



Over the past seven years, investors in bonds have seen the phrase “bond risk” thrown around much more often than they would ever have imagined ten years ago.   And, over the past year, they have become almost commonplace in discussions about short-term movements in the yields of bonds.

In speaking of risk on and risk off in this case, I am talking about international flows of funds in-to and out-of sovereign bond markets around the world.  As investors get shaky about the “climate” surrounding the debt of a county or a region, they flock out of that debt and into the debt of another country or region.

As the “climate” surrounding that debt subsides, then money begins to flow back into the country.

In the meantime, these flows of funds can cause some pretty substantial swings in interest rates and bond prices.  To pick up the timing of these flows I look at the yield on the 10-year United States Treasury Inflation-Protected securities (TIPS).

Most recently we have the market’s reaction to the events in the Ukraine.  The intensity of political protests in Kiev, the capital of the Ukraine, picked up during the week beginning Monday, February 17.  On Thursday of that week, the yield on the 10-year TIPS closed at 0.614.  On Friday, President Victor Yanukovyck disappeared, the Ukrainian Parliament voted him out of office, and political prisoners, like the ex-premier, were released from jail.

That Friday, the yield on the TIPS dropped more than 30 basis points as money started to flow out of the Ukraine and Russia and into some “safe haven” investments.  By Thursday, February 26, the yield had dropped to 0.465 percent.

On Monday, March 3, the presence of Russian troops was observed in Crimea.  Not only did the yield on the 10-year TIPS drop to 0.416 percent, the Dow-Jones Industrial Stock Index fell by more than 150 points, being down well over 200 points at one time.

The international flow of risk averse funds was huge.  The United States was a safe haven.

This kind of behavior also occurred in late December 2013 and January 2014.  This time the event that kicked off the movement of funds was the action taken by the Board of Governors of the Federal Reserve System.  In this case, Federal Open Market Committee of the Board of Governors voted to begin to “taper” the amount of bonds that were being purchased each month as a part of the Fed’s third round of quantitative easing.

The investors that got scared at this time were those that had invested in the bonds of the countries referred to as emerging market nations.  The concern was that a lot of the money the Fed had pumped into the US financial system over the previous year or so had gone into these emerging market nations.  With the “tapering” the fear was that these monies would flow back into the United States and the interest rates in these emerging market countries would rise.  Hence, the flow of risk-averse money from these markets back into the United States.

In the closing days of 2013, the yield on the 10-year TIPS was just below 0.780 percent.  By January 24, 2014, the yield was down to 0.485 percent.  I have written about this in an earlier LearnBonds post.

As cooler heads come to prevail in the financial markets, the yield on these TIPS moved back up to the 0.614 level mentioned above.

The point is that in the internationally connected bond markets, these disruptions seem to be picking up in not only in terms of frequency but also in terms of volatility.

I mention that the current cycle of risk on-risk off movements seemed to begin just before the start of the Great Recession, a time when investors really began to get jumpy about what was going on in financial markets.

The yield on 10-year TIPS reached a peak in the month of June 2007.  In that month the yield averaged 2.69 percent.  It remained around that level through July before some disruptions hit the financial industry.  In August, the rate really dropped as the average fell to 2.44 percent.

The Great Recession began in December 2007and in January 2008 the yield averaged 1.47 percent.   In March 2008 the yield was down around 1.00 percent.

The initial reaction of investors in the world was to put their funds into the safest security they knew…US government bonds.

But, then as world market seemed to stable, funds began to rapidly flow back out of the United States.  By November 2008, the yield on these 10-year TIPS jumped up to an average of 2.89 percent.

The Great Recession was declared over in July 2009.  At this time, we got the first of two international funds movements that brought huge amounts of money into the United States.  Both of these periods can be connected with investor’s insecurity with European debt.

The first of these was a relatively slow movement of funds out of Europe as concerns grew about the fiscal state of Greece, Ireland, and Portugal.  From the high of 2.89 percent just mentioned, inflowing funds from European financial markets drove down rates to around 1.00 percent in the last four or five months of 2010.

Then in early 2011 the next shock wave of funds fled the European continent and this flow of money drove the yield on 10-year TIPS into negative territory.  In the fourth quarter of 2012, the yield on 10-year TIPS was a NEGATIVE 0.760 percent!

In early 2013, it appeared as if the eurozone was getting its act together and money started to flow back out of the United States and into Europe.  As a consequence, Treasury bond yields started to rise again.  In June 2013, the yield on the 10-year TIPS regained positive territory.  And, rates continued to rise until, as was told above, the concern over Federal Reserve “tapering” arose and we got another flow of money throughout the international markets.

The point of this post today is just to call attention to how jumpy people currently are in the international bond markets and how well connected all the markets of the world are.  This just means that investors in bonds have one more thing to worry about in trying to understand the forces that are impacting longer-term interest rates these days.

This is something we are all going to have to deal with and it is something that we need to incorporate into our understanding of what impact the Federal Reserve is having on the financial markets and the economy.  For example, to me, the Federal Reserve did not drive interest rates below zero in 2011 and 2012.  The reason why these rates went into negative territory was because of the risk averse behavior of many, many investors in international financial markets.  The return to positive yields in early 2013 was also not the result of Federal Reserve actions, but was the result of outflows of funds back into Europe.  I believe that this explanation helps a lot in terms of understanding the events of recent times.

About John Mason

John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.

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