Government bonds have long enjoyed a special place in investors’ portfolios. Often seen as a cornerstone of stability, their appeal as a safe haven is rarely questioned. Yet, recent years have painted a different picture, revealing a story of diminishing liquidity and increasing volatility that should give investors pause.
This week, we turn our attention to liquidity—an often overlooked but crucial element in the financial markets. Anyone familiar with market dynamics knows that liquidity is a key driver of both short-term volatility and long-term performance. It’s a basic principle that lower liquidity demands higher compensation.
However, when it comes to government bonds, liquidity seems to slip under the radar. This is surprising, given that liquidity in bond markets has been drying up steadily for years. The chart below illustrates a liquidity measure for US, Japanese, and German government bonds. As the lines rise, liquidity decreases, and vice versa.
Over the past three years, liquidity in bond markets has consistently declined. Various factors contribute to this trend, with central banks’ actions—raising interest rates and scaling back bond purchases—being among the primary culprits. A glance at the Federal Reserve’s reverse repo facility, where banks and money market funds park their cash for a decent return, is telling. Over the past 12 months, the reverse repo balance has dropped by a staggering 2 trillion dollars.
Unrest and volatility
A direct consequence of dwindling liquidity is heightened volatility. The following chart shows the MOVE Index, which tracks implied volatility in the US government bond market. For several years now, both implied and realised volatility have been significantly higher than the long-term average. Recent bond yields have not only been volatile but have also exhibited a striking degree of unpredictability.
Time for reflection
It’s not unusual for an asset class to experience a temporary spike in volatility, but this has been a prolonged affair—spanning years, not weeks. Such sustained volatility is beginning to impact the long-term assumptions that many traditional investors rely on for their strategic asset allocation. Moreover, the likelihood of continued high volatility is becoming increasingly apparent.
As liquidity dries up, a higher risk premium is required, a situation exacerbated by the massive fiscal deficits we’re witnessing. This raises the question: who is willing to take on all this debt? Central banks, facing the reality that the debt-laden financial system cannot endure too many rate hikes, are pressured to keep interest rates down—especially in times of recession or crisis. This ongoing tug-of-war between the market and central banks inevitably breeds more volatility.
Enter ‘the great rebalancing’
The longer this elevated volatility persists, the more traditional investors, armed with their mean-variance optimisation models, will need to reconsider their bond allocations. And that’s without even delving into the other crucial factors—yield and correlation.
As the characteristics of bonds remain less favourable than in the past, investors are being pushed, sometimes by necessity, to rethink their strategic mix. This shift is what I call ‘The Great Rebalancing’. So, the question remains: have you started yet?
Jeroen Blokland analyses eye-catching, topical charts on financial markets and macroeconomics in his newsletter, The Market Routine. He also manages the Blokland Smart Multi-Asset Fund.