To say that the past year has been an uncomfortable one for European government bond traders is clearly an understatement. At the mercy of politicians, policymakers and ratings agencies, they have been expected to maintain liquidity to their client base in full knowledge that at any moment an adverse headline could move the market tens or even hundreds of basis points against them and leave them trapped on the wrong side of the pricing divide.
"The job of liquidity provider in Europe has been extremely difficult during 2011, especially in the past month with the political instability, and that has really damaged the global picture," says Franck Motte, head of global rates at HSBC.
Nonetheless, he and other dealers are keen to stress that, despite the repeated upheavals and soaring baseline volatility, markets have remained functional throughout the year. "Liquidity has deteriorated as country spreads have widened but if a client has needed a price theyve always been able to get it," says Nat Tyce, head of rates trading, Europe, at Barclays Capital in London.
And as Motte points out, the fact that European sovereign borrowers had succeeded in raising around 800bn over the course of the year also testifies to the resilience of government bond markets. "Some may complain about the fact that bid-offer spreads look wider on screen but nevertheless we managed so far to run the whole funding programme in the euro sovereign space this year, which means that the liquidity has still been pretty much there," he says.
Bid-offer spreads have clearly, however, been a lot wider even in markets close to the core something dealers say clients have simply had to get used to. "They have had to adapt to the volatility," says one. "They realise that you cant have a very tight bid-offer spread if a market is moving 25bp or 50bp in a day, so theyve been quite happy to get a price at all."
Dealers are reluctant to cite specific numbers, given the endemic volatility, but agree that the leading characteristic of their market throughout the year has been the gaping differential between the various Eurozone sovereign instruments.
"Bunds have typically been very liquid and most transactions have occurred a fraction of a basis point from mid, but at the other extreme some Greek government bonds could trade several points from mid depending on the size of the trade going through," says one. "Everything else has been somewhere between those extremes."
As the contagion has reached closer to the core, bid-offer spreads have inevitably widened or even disappeared in mid-November some banks were said to be trading Italy on an order-only basis as the outright markets were too wide but again dealers insist that the reality on the ground had not been as bad as it had sometimes looked from the outside.
"The market has remained competitive and in the core countries a lot of client activity still occurs close to mid," says Tyce at BarCap.
Others note that cut-throat competition between market makers had provided some welcome relief to hard-pressed buy-side participants. "The mode of trading has changed," says one dealer. "You can no longer turn your trade around at mid-price but sometimes you can actually do it in a better way, given the very aggressive competition that has amazingly been there all year long."
Motte at HSBC agrees. "Despite the fact that the liquidity theme has been extremely under pressure given the volatility, competition has remained extremely high," he says.
"As an example, when the ECB came to buy a decent chunk of non-core, the sort of prices they were getting have been really impressive. The competition was there and the pricing was extremely aggressive."
Central bank activity
The ECBs buying has, of course, been central to the market in many ways over the four months. Since restarting its Securities Markets Programme in a surprise move on August 8, the central bank has bought more than 130bn of Spanish and Italian government bonds an intervention that Renos Dimitriou, head of European government bond trading at RBS in London, says was crucial to the continued health of the markets.
"Liquidity has dramatically decreased in most markets and if hadnt been for the ECBs SMP programme then the liquidity would have been even more dramatically decreased and the market would be completely dysfunctional," he says.
"The fact that the ECB comes on a systematic basis and buys paper has definitely provided some stability to the market in regard to investors being able to unwind some of their positions in the periphery. If it wasnt for that, that paper wouldnt find a home and there would be a lot more trapped positions."
But while most dealers acknowledge the value of the ECBs interventions, several would like to see the SMP extended to bonds with maturities beyond 10 years and to other stressed areas, such as the inflation-linked market. They are also quick to highlight the limitations of the banks current remit in terms of stabilising the markets. As Tyce at BarCap says: "ECB buying has had an impact but the market remains under stress."
Dimitriou says that the SMP programme had failed to fully restore market confidence. "If it had trading wouldnt be at these valuations," he says. "What it has done is allowed investors to unwind some of the positions that they dont want to hold and that the banks cant take on their balance sheet."
Inevitably, this has had the unintended consequence in some cases of narrowing the buyer base, as overseas investors in particular have headed for the exits. "Investors outside of Europe in 2011 have been wary of the European situation as they dont understand what is going on and theyve been reallocating most of their new cash to the Japanese market, UK market and US market," says Motte at HSBC.
In the periphery this has been, to some extent, made up for by the arrival of investors with a higher risk appetite, in the shape of credit and even emerging market funds, but new money inflows have so far been lower than some market participants had hoped.
"We have seen a certain amount of high-yield buying but it has been very limited," says one dealer. "For the markets that have traded at distressed levels Greece, Portugal and Ireland there has been some activity, but in the context of the overall market its a relatively small part of the investor base."
Hedge funds another buyer group that has once again garnered a disproportionate amount of interest from press and politicians are also said to be noticeable by, if not their absence, then their relative insignificance in broader market terms. Most dealers are certainly scathing of suggestions that speculative money has played a part in precipitating all or any of the liquidity problems this year.
"This crisis hasnt been caused by hedge funds," says one. "Economic weakness has been driving this market and the failure of governments to do their own homework. Hedge funds are active in the market but in terms of position size and volume theyre not among the most significant clients. I dont believe any of these market moves are due to the actions of speculative traders."
Motte agrees that hedge funds doing value trades have been less active in 2011, but adds that this had been partly compensated for by a high level of demand from reserve banks, central banks, asset managers and insurers. Other dealers, however, note that even core investors have in many cases been reducing their activities as conditions have worsened over the course of the year.
"In broad terms the market participants are the same as in 2010 but what we have seen is some investors have narrowed the countries they will invest in, particularly institutions that are most conservative such as pension funds," says Tyce at BarCap.
Flight to quality
Dealers report the introduction of similar limitations among a portion of the overseas buyer base. For some this has meant restricting themselves to triple-A names or even, in several cases, narrowing it down still further to a sub-set of that sector while for others it has been a question of reducing their allocations to countries as their securities become more volatile and trade on wider spreads.
Inevitably the main beneficiary of this has been Germany, as evidenced by 10 year yields as low as 1.75% at times and short end yields close to zero. "The markets have been very volatile in terms of switching from risk-on to risk-off, so on risk-off days Germany has traded very well," says one dealer. "In a volatile market you always switch from periods when everyones trying to buy to periods when everyones trying to sell, its just a typical example of that kind of market."
This effect has been particularly pronounced since the Eurozone contagion effect finally reached France in late autumn as the prospect of presidential elections next year combined with deepening concerns over Italy and a growing awareness of the high percentage of non-residents among holders of French government debt began to rattle investor nerves.
"The liquidity on France has been reduced quite a bit and the volatility has increased to very high levels, which is making end buyers shy away from the market," says Dimitriou at RBS.
That leaves Germany as the only market with sufficient scale to offer investors a safe haven from the prevailing volatility. "There has been a general widening of spreads versus Germany, which is partly to do with concerns about creditworthiness and partly a function of liquidity," says one dealer.
Thus the debt of well-run but smaller sovereigns such as Finland and the Netherlands has widened against Bunds as investors have sought safety in numbers. "Finland is a very strong credit but is too small a market really to be a flight to quality market," says one dealer.
Tyce at BarCap agrees: "Germany is a deep and liquid market so its the natural choice of flight to liquidity moves within the Eurozone."
But if investors have been increasingly picky in terms of name selection, the same cannot be said of their choice of maturities dealers report that nearly all markets have seen activity right across the curve over the course of the year.
"We had a run on the long end, we had a run on the medium term, we had a run on the 10 years," says one. "Clearly with the ECB buying in the second part of the year the activity was more centred on the eight to 10 year area but weve seen a lot of interest on the long end of Germany and in the last couple of days (mid-November) weve seen a lot of selling in France out to 50 years."
The sporadic and headline-driven nature of trading in many of these markets has, however, meant that long-established correlations between credits have broken down presenting a new challenge to market makers accustomed to using related instruments rather than direct hedges to offset positions.
"In stressed markets previously stable relationships can change some countries could be widening, other countries tightening, some countries flattening and others steepening," says Tyce. "That makes liquidity provision more challenging because you have to be very careful in your choice of hedges."
And to make dealers lives still more difficult, secondary market sensitivity to primary activity has been building throughout the year Eurozone sovereigns may have succeeded in completing their funding, but it has come at a cost.
"As price action indicates, auctions have become more difficult to digest and as a result they weigh heavily on the secondary market," says Dimitriou at RBS. "Were seeing that the market requires more concession going into an auction in order to be able to buy the paper."
Nevertheless, he and others insist that relationships between market makers and the various debt management offices have remained positive even in periods of severe stress. "The DMOs have been very keen to hear what we think about the markets and theyve taken a lot of advice on how to better fund themselves," he adds. "Its been a very constructive relationship for both sides in these times of crisis."
With the future of their market hanging by a thread, most European govvie dealers were reluctant to identify any potential trends for 2012 apart from a continuation of the relentless volatility of recent months. But those prepared to look further ahead worry that regulatory reform across the industry could have even further-reaching and longer-lasting effects than the eurozone troubles.
"Theres a barrage of regulations coming our way people are saying theres a tsunami of regulations and that trying to read them is like trying to drink water from a fire hose," says Roger Barton, consultant at electronic platform provider MTS.
He points to proposed legislation on trading transparency, mandated by the G20 in the wake of the last financial crisis and now making its way through the various European bodies. The details have yet to be worked through and any changes are not expected to be implemented before 2013, but Barton warns that the process risks damaging liquidity in financial markets.
"If you make it more difficult for banks to lay off large trades then what they will do is reduce the size of the positions theyre prepared to take on," he says. "Its important in the fixed income markets particularly to calibrate the transparency to take into account the characteristics of the market: for example to delay the publication requirements for trades over a certain size or trades of relatively illiquid products."
Dealers are on the whole more sanguine about the effects of transparency legislation, stressing that despite the market dislocations of the past two years electronic platforms a central plank of the proposed legislation are a growing component of government bond trading.
"Theres a secular trend towards electronic trading and then there are variations when the markets very volatile," says Tyce at BarCap. "In 2008 during the crisis there was a dip in the share of business that was trading electronically but that soon recovered, and this year for us at least its reached a record high proportion."
But if transparency legislation is seen as more of a headache for the derivatives sector, govvie traders voice deep concerns about the possible effects of increased capital adequacy requirements on their market.
"What I am worried about is that the new capital requirements will ultimately lead to a reduction of balance sheet," says one. "Market making activities will probably be affected by an overall decrease of capital that can be used for the business."
Motte at HSBC adds that the sector is already feeling the adverse effects of mark-to-market requirements imposed on insurers by Solvency 2. "They are now much closer to the market stories," he says. "When the equity market is moving down theyre getting scared, when the bond market is moving down theyre getting scared, and clearly this is part of the volatility that were running, because its coming from the regulatory format that we have to work with."
Other market participants are more philosophical, pointing out that the still fragmentary and uncertain nature of potential changes in regulation make it next to impossible to devise strategies to deal with them. "Theres clearly a lot of change going on on the regulatory side but the industry doesnt have all the details yet, so we just try to understand it as best we can and prepare as best we can," says one.All agree, however, that secondary market conditions over the coming year will likely remain extremely challenging, both from a market and a regulatory perspective. The hope is that they wont be quite as traumatic as they have been in 2011.