(Bloomberg) -- The surge in government bond yields around the world to the highest this year isn't just because of signs of economic improvement. A lack of liquidity is amplifying the move.
The average yield on sovereign securities climbed to 1.34% Tuesday, the highest since Dec. 26, based on Bank of America Merrill Lynch indexes. The securities have lost 2% this quarter after accounting for interest payments. As yields rise, price swings have been exacerbated as major Wall Street firms have reduced their market making role. In the U.S. a measure of volatility rose Tuesday to the highest level in two weeks.
The European Central Bank and Bank of Japan are both snapping up record amounts of government debt as they try to spur their economies, a policy known as quantitative easing. The ECB increased purchases in May before the region's summer vacation period. The Federal Reserve's Treasury holdings are near a record after a bond-buying program that lasted from 2008 to 2014.
Two things happened as a result. Investors revolted against German 10-year bond yields that approached zero, and the lack of depth in the market increased the size of the move once it started.
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"At the source of this selloff is the fact that yields were at ridiculous levels," Francesco Garzarelli, co-head of macro and markets research at Goldman Sachs in London, said in an interview on Bloomberg Television's "On The Move" with Jonathan Ferro. "The bond market is not as elastic as it used to be and that's because of all the regulations and balance- sheet constraints."
In the U.S. the Bank of America Merrill Lynch's MOVE Index, derived from over-the-counter options on Treasuries maturing in two to 30 years, rose to 87.48 on Tuesday, the highest level since May 22.
Benchmark U.S. Treasury 10-year yields rose four basis points, or 0.04 percentage point, to 2.30% as of 9:14 a.m. New York time, according to Bloomberg Bond Trader data. They have climbed from this year's low of 1.64% set in January. The 2.125% note due in May 2025 fell 11/32 to 98 13/32.
German 10-year yields have increased to 0.79% from the record low of 0.049% set in April. In Japan, they are 0.465%, more than double their January level.
"It's pretty much driven by Europe," said Yusuke Ito, a fund manager in Tokyo at Mizuho Asset Management, which oversees $32 billion. "Because of the ECB's quantitative easing, the liquidity there is pretty scarce. Under that kind of situation, it's pretty easy for the yield to go up or down."
Yields are increasing amid signs the global economy is responding to the record central-bank stimulus being applied. Data this week showed euro-area consumer prices rose in May for the first time in six months on an annual basis, while U.S. manufacturing and construction spending are accelerating. Japan's economy expanded for a second quarter, figures last month showed.
Regulations requiring market participants to reduce risk are adding to the lack of liquidity, said Hajime Nagata, who invests in Treasuries for Tokyo-based Diam Co., which oversees the equivalent of $140 billion. The result is that market makers have fewer bonds in inventory, he said.
The Volcker Rule and Basel III regulations require banks to cut back on risky trading activities and holdings, leading them to scale down their bond-trading businesses.
For Treasuries, the share of transactions by primary dealers has dwindled by more than half to 4% since the end of 2008, according to the Institute of International Finance, a lobbying group for banks.
In the past year, JPMorgan Chase, Morgan Stanley, Credit Suisse Group and Royal Bank of Scotland Group have either cut back their fixed-income trading desks or are weighing reductions in those businesses.
That has all led to exaggerated moves in bonds, according to Diam's Nagata. "All of a sudden, bond prices are going down," he said.
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