Bond market crash is the biggest worry for the Bank of International Settlements

Posted on 15 October 2014 with no comments from readers

A sudden and precipitous fall in the bond market is the biggest worry at the Bank of International Settlements, the central bank for the central banks based in Basel, according to Guy Debelle, head of the BIS’s market committee.

Speaking in Sydney and cited in The Daily Telegraph today, he said: ‘The sell-off, particularly in fixed income, could be relatively violent when it comes. There are a number of investors buying assets on the presumption of a level of liquidity which is not there. This is not evident when positions are being put on, but will become readily apparent when investors attempt to exit their positions. The exits tend to get jammed unexpectedly and rapidly.’

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True believers

Mr. Debelle thought it strange that bond market participants seemed to always believe what central banks told them: ‘I find it somewhat surprising that the market is willing to accept the central banks at their word, and not think so much for themselves…That is a point we haven’t started from before. There are undoubtedly positions out there which are dependent on (close to) zero funding costs. When funding costs are no longer close to zero, these positions will blow up.’

Many firms have also left the bond market leaving it particularly vulnerable in a sell-off, he noted: ‘Market liquidity is structurally lower now than it was in the past. The question today is whether there is too little capacity. When volatility returns, it may well rise quite rapidly.’

Mr. Debelle pointed back to the US treasury bond crash of 1994, but warned that it could be even more violent this time with a ‘fair chance that volatility will feed on itself.’ What would this mean for global investors?

If history if any guide then when bond markets blow-up precious metals are usually the only asset class left that investors trust. The rotation is first into gold and silver, and because of supply constraints the impact on their price is dramatic.

Investment implications

The price of real estate and stocks will crash too because the cost of money suddenly becomes dramatically more expensive and that upsets many business models and bankruptcy and bank failures follow. Eventually prices will stabilize and look attractive to those owning precious metals and the cycle can begin again.

Bond markets are like any other and rise from one extreme to another before falling. What is different this time as Mr. Debelle highlights is the degree of exaggeration due to central bank interventions since the global financial crisis. If he’s right this is about to blow-up in their faces as the most dramatic policy failure of all time.

The BIS is hardly a fringe newsletter writer trying to generate an audience. It’s perhaps the last bastion of commonsense in a world gone mad.