The “Real Flash Crash” Will Scare You to Death
Stock-Markets / Financial Crash May 23, 2015 - 11:41 AM GMTBy: ...
MoneyMorning.com 
Shah Gilani writes: Just about every investor knows about the stock-market “Flash Crash.”
Even though it happened all the way back on May 6, 2010, this historic sell-off has been all over the news lately as U.S. regulators try to extradite a small-time London-based trader they’ve identified as the cause.
That’s rubbish. Stocks don’t crash because one trader put down bunches of “sell” orders.
But today I want to tell you a story… about another Flash Crash.
It was bigger and more frightening than the 2010 Flash Crash.
It happened a lot more recently – in October 2014.
But most investors know nothing about it.
And they need to.
This “other” Flash Crash is another example of the lack of market liquidity we’ve been telling you about lately.
It’s a market Disruptor – one that can sting you badly if you don’t know about it… or make you rich if you do….
Once Every 3 Billion Years
This “other” Flash Crash hit the U.S. Treasury bond market back on Oct. 15.
Bond yields plummeted in an “unprecedented” manner, said JPMorgan Chase & Co. (NYSE: JPM) CEO Jamie Dimon – who described it as “an event that is supposed to happen only once in every 3 billion years.”
I’ll tell you what really happened, why it happened and what’s so frightening about it.
In the 2010 Flash Crash, the Dow Jones Industrial Average plunged 998 points, or about 9%, in 36 minutes. That was the biggest intraday decline in the Dow’s entire history.
Then, last Oct. 15, some not-so-good economic news came out in the morning. Retail sales for September fell 0.3%. The producer price index (PPI) declined 0.1%. And the Empire State Manufacturing Survey showed “the pace of growth slowed significantly from last month.”
Because bad economic news means the U.S. Federal Reserve likely won’t dare raise interest rates, we were in a “bad-news-is-good-news” period for bonds. (We’re still there today.)
When the bad news came out, bond prices rallied. Prices for the Treasury’s 10-year maturity bonds didn’t crash, they shot up. What crashed was bond yields, not bond prices.
Let me show you with a simple lesson you’ll never forget.
Bonds, as you know, pay interest. And for bonds, price and yield are inversely correlated. That’s important to understand.
Let’s say you bought a 10-year bond with a 2% “coupon” (that’s the interest) and paid $100 ($100 is “par”) for it.
Sometime later, the issuer of your bond sells the same 10-year bond with attached interest of 3% and a price of $100.
That means the price of your bond will change.
Here’s why. Someone who comes along and wants to buy a 10-year bond now has a choice: to buy your bond or to buy the new 10-year with the higher coupon.
Obviously, he’d buy the new bond for $100 to get more interest. So, in order for you to be able to sell your bond, you will have to lower the price to some level where the amount someone pays is so much less than $100 (in other words, a discount from par) that the amount he pays (invests) turns the 2% yield into a 3% yield.
To give you some perspective, the price we’re talking about here is around $66.67.
Bonding With Bonds
Now the bonds are essentially the same to any buyer. The discount is a mathematical formula. That’s why bond prices go down when interest rates go up. Similarly, if interest rates go down, the price of your bond would go up, because it pays more interest than new bonds coming out. And because it pays more, the price someone will pay you is higher than par. That’s the same mathematical formula.
Now that you understand that when bond prices rise, bond yields fall, we can talk about the Treasury Flash Crash. Because what actually happened was a huge price rally – meaning the crash was in yields.
From 9:33 a.m. to 9:45 a.m. the morning of Oct. 15 – a scant 12 minutes – the yield on the 10-year plunged from 2.15% to 1.86%.
That’s huge.
Thanks to the “bad-news-in-the-economy-is-good-news-for-bonds” backdrop, the disappointing economic reports meant the Fed wasn’t going to lift rates, which meant it made sense for investors to buy existing bonds.
At the same time, the 10-year yield was at “support,” meaning the yield had come down enough that traders were betting it wouldn’t go any lower. In fact, traders were expecting better economic news and yields to start rising.
Treasury bonds are traded by every big bank in the world: The market is gigantic – about $12.5 trillion, according to a recent Bloomberg analysis.
The job of traders is to make money. Because a lot of them expected yields to rise and prices to fall, there were a lot of “short” positions. Shorting bonds is the same as shorting stocks: You short them expecting the price to go down, so you can buy them back cheaper for a nice profit.
Just at the moment when traders – most of them watch the same metrics and use the same support and resistance and trend lines by way of technical analysis – were short at the 2.25% yield level, the bad economic news caused buyers to come into the market. As prices rose quickly (and yields fell), shorts had to start covering quickly in order to not lose massive amounts of money on their short positions.
That’s what caused bond prices to spike – causing the Flash Crash in bond yields.
That’s what happened.
But it’s not the story.
Less Liquidity Than the Atacama?
The U.S. Treasury bond market is considered, by far, the most “liquid” market in the world.
What’s frightening is that bond prices could move so much, so fast, in that market.
It’s never happened before.
Mathematically, it was close to an eight-standard-deviation (eight sigma) move.
That’s insane…
While it’s an exaggeration to say it’s a “one-in-3-billion-year event” (the bond market hasn’t been around that long, nor have traders), it’s not crazy to say the move was… well… crazy.
In fact, it’s actually crazy-frightening: If it can happen on a “rally” in prices, meaning yields fell, it can just as easily happen in reverse.
Why is that crazy-frightening? Because banks and institutions and hedge funds and governments own trillions of dollars of bonds.
If prices fall instead of rise – as quickly as we now know they can – they all lose money on a mark-to-market basis (meaning on-paper, if they don’t actually sell). They could all lose hundreds of billions of dollars.
What the bond-market Flash Crash showed us is there isn’t the same old liquidity in the bond markets that there used to be. Like the stock market now, bonds can crash.
We’re hearing a lot of worried voices about bonds being vulnerable these days – both from some of the biggest players in the bond market and from Fed Chair Janet Yellen.
(In that recent Bloomberg analysis we referenced, big traders said the U.S. government debt market has lost a significant amount of its “depth,” or ability to handle big trades without having prices move. A year ago, traders said they could move about $280 million worth of Treasuries without causing prices to move. Now it’s only $80 million, JPMorgan Chase says.)
The risk is actually even higher than most people know.
Between computerized trading machines now wreaking havoc on the bond market and the global – yes, I said global – lack of liquidity in bond markets, something will happen.
We’ve been talking a great deal lately about market Disruptors – including, of late, market liquidity.
When it comes to Disruptors, there are lots of them. And when it comes to markets, there’s one giant disruptor, liquidity, specifically the lack of it and how bad that is for markets.
If the lack of market liquidity was a Disruptor category, it would be the biggest of them all.
I’ll tell you the full extent of the liquidity crisis in the bond markets next time. I’ll also tell you what to look for to know when the bottom is about to fall out – and how you can make a ton of money if you play it right.
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