Treasury market volatility is highest in three years


By Elizabeth Stanton and Daniel Kruger
Bloomberg News Service
Tuesday, September 4, 2007

NEW YORK -- The global flight to the safety of government debt is causing the widest price swings in Treasuries in three years, driving away traders who rely on computer models to guide their strategies and raising costs for investors.

Volatility rose last month to the highest since May 2004 as investors, jolted by losses in securities contaminated by defaulted subprime mortgages, bought U.S. debt, according to data compiled by Merrill Lynch & Co. Morgan Stanley, the second-largest U.S. investment bank by market value, responded by stopping computer-driven buying and selling of Treasuries, said Sanjay Verma, head of U.S. government bond trading.

The retreat by so-called black-box traders and hedge funds caused orders for Treasuries to drop as much as 80 percent, said Mark Ficke, senior managing director at ESpeed Inc., the second-biggest interdealer broker. Securities firms increased commissions as much as nine-fold to avoid losses should offers to buy or sell bonds suddenly disappear, according to Mark MacQueen, a partner at Austin, Texas-based Sage Advisory Services Ltd., which oversees $5 billion.

"If you're flying an airplane on instruments and you run into a hurricane you're probably going to put your hands back on the wheel and pay closer attention," said John Roberts, managing director of government bond trading at Barclays Capital Inc. in New York. "From a trading perspective perhaps you reduce the amount of risk. Some guys pull the plug completely."

Merrill Lynch's MOVE Index, an options-based gauge of expectations for price swings in Treasuries, touched a three-year high of 118.5 on Aug. 9. The reading means traders expect a yield range of 118.5 basis points on an annualized basis in the coming month. The index fell to a record 51.2 in May. A basis point is 0.01 percentage point.

"There's no question that even the most liquid market in the world, the Treasury market, has been facing bouts of illiquidity, occasional discontinuous pricing, and more anomalies than you normally get," said Paul Yablon, head of global macro proprietary trading at RBS Greenwich Capital in Greenwich, Connecticut. "It's typical of a financial crisis environment."

The price swings showed up most in the market for Treasury bills, the safest securities with the shortest maturities. There were 15 days last month when yields on three-month bills swung by 10 or more basis points, according to data compiled by Bloomberg. That happened only six days from the start of 2002 through July. There were only five such swings in the aftermath of the September 2001 terror attacks.

"Volatility's going to lead to wider spreads, less liquidity, and more risk," Sage Advisory's MacQueen. "You're paying a little more to get transactions done."

The difference brokers charge to buy and sell Treasury bills widened to 20 basis points last month from the typical 1 basis point, he said. That means commissions on a $1 million order swelled to $185, from about $20.

Government bonds rallied for a third week after Federal Reserve Chairman Ben S. Bernanke said Aug. 31 that the central bank will "act as needed" to keep "disruptions in financial markets" from slowing the economy.

The benchmark 10-year note's yield dropped to 4.53 percent Aug. 31, down 79 basis points from the five-year high of 5.32 percent on June 13. The price of the 4 3/4 percent note maturing in 2017 rose to 101 3/4 last week from 101 3/32 on Aug. 24, according to bond broker Cantor Fitzgerald LP, which controls ESpeed.

Until a month ago, the interdealer market where firms trade anonymously typically had bids and offers for at least $500 million of two-year notes at the quoted market price, said ESpeed's Ficke. Last week the amounts were about $100 million, he said. New York-based ESpeed operates one of the two largest interdealer broker systems behind ICAP Plc.

Computer programs for trading operated by hedge funds or Wall Street firms, known as black boxes because only insiders know the variables that run them, "have taken a less aggressive stance with the increase in volatility," Ficke said. "That in itself creates less liquidity."

Hedge funds accounted for about 30 percent of bond trading in the year through April, second behind money managers, according to Greenwich, Connecticut-based research firm Greenwich Associates. That was double the amount of bond trading hedge funds did in the previous 12 months.

"We turned them off two months ago, at the beginning of July," Morgan Stanley's Verma said of the black-box models. The New York-based firm was "quicker than others" to do so, he said.

Volatility in Treasuries has increased as losses in the market for subprime mortgages to people with poor or limited credit pushed up borrowing costs for consumers and companies. The U.S. market for commercial paper, corporate debt maturing in 270 days or less, shrank for a third week, extending the biggest slump in at least seven years, according to Fed data.

As traditional lenders to companies refused to provide credit, the Fed cut the interest rate on loans to banks on Aug. 17 and central banks pumped more than $200 billion into the money markets. President George W. Bush pledged Aug. 31 to help homeowners unable to pay their loans by allowing the Federal Housing Administration, which insures mortgages for low-and middle-income borrowers, to guarantee loans for delinquent households.

Trading averaged a record $767 billion a day last month, according to Fed data tracking the 21 firms that underwrite Treasury bond auctions. That's a reversal from last year when trading by the so-called primary dealers fell for the first time since at least 2001. Transactions averaged $525.2 billion a day, down 5 percent from a record set in 2005.

"We're still in very volatile markets, and as a trader I appreciate volatility," said Theodore Ake, head of U.S. government bond trading at primary dealer Mizuho Securities USA Inc. in New York. "I just want liquidity with my volatility."

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