Analysis: Old normal for bonds rather than fragile new world

Wed Jul 10, 2013 1:55am EDT
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By Mike Dolan

LONDON (Reuters) - The global bond market shock of recent weeks may be closer to an 'old normal' than some new world of fragile, over-regulated markets posited by many banks and brokers to explain the rout.

One narrative behind the surge in bond yields around the world since May has been that complacent investors simply overreacted to the relatively mild prospect of gradually less bond buying by the U.S. Federal Reserve over the next 18 months.

That certainly seemed to be the view of central bank policymakers in Europe and around the world last week.

But, perhaps unsurprisingly, some in the banking world lay the blame for the outsize reaction on tighter post-crisis regulation of bank capital, risk taking and in-house dealing.

The suggestion is that new laws aimed at preventing excessive risk in banking - such the Dodd-Frank on overhauling Wall Street, the Volcker rule on stopping proprietary trading or even the European bans on speculative trading in credit default swaps - have had their first stress test and the results are not pretty.

By crimping the capacity of the broking and dealing world to absorb and mediate heavy investor sales, the argument goes, then markets are now more prone to such sudden evaporation of market liquidity and savage price swings - particularly in lower-rated emerging market debt or corporate junk bonds.

One alarming contrast shows the size of U.S. corporate bond market expanded by about $2 trillion since the credit crisis hit in the summer of 2007 to more than $5 trillion - but primary dealers' corporate bond positions have fallen to about a third of 2007 levels to less than $100 billion.

Initial 'overreactions' then feed off themselves as short-term players herd to the exits while ever wider price swings deter buyers and banks sensitive to spikes in volatility-driven 'value-at-risk' models.   Continued...

A trader works on the floor of the New York Stock Exchange as The Federal Reserve rate announcement is shown on a screen, November 3, 2010. REUTERS/Brendan McDermid