The Anatomy of the Bond Market Turbulence of 1994

According to Claudio E. V. Borio and Robert N. McCauley, "the bond market sell-off of 1994 has begun to show up on lists of market events against which risk management systems are judged." Examples of other such events are the 1987 stock market crash and the 1995 Kobe earthquake. However, there has been little analysis of the cause of the 1994 decline. Borio and McCauley fill the void by examining a number of factors that might explain the rise in volatility during that year. The authors investigate four types of one such factor, market dynamics: volatility persistence, relationships in the direction of market movements, foreign disinvestment, and volatility spillover effects from other markets. Borio and McCauley found that persistence had strong explanatory power. The implied bond volatility in two successive weeks accounted for 58 to 93 percent of the variance in volatility. They found "strong but not ubiquitous evidence" that a rise in bond yields led to higher volatility. In the United States and Canada they found no relationship between bond prices and volatility. In Japan, Sweden, and Spain, however, they found a symmetrical directional relationship, that is, increases or decreases in bond yields resulted in similar increases in volatility. In the remaining eight countries they studied, they found a partial directional relationship between volatility and bond prices, that is, volatility rose when bond yields rose, but did not respond when yields fell by a similar amount. The authors offer several possible explanations for the apparent directionality of volatility, including asymmetries in inflation risks and options trading strategies. Borio and McCauley found that international capital flows played a role in the rise in bond volatility in 1994, especially for European countries that experienced a sell-off of government bonds. The sell-off, the authors explain, reflects "the greater proclivity among foreign investors to leverage their holdings of bonds." The authors found that spillover effects were not a factor that could explain the general rise in bond market volatility. Borio and McCauley also investigate other factors that might contribute to bond market volatility. They find some evidence that uncertainties about monetary and fiscal policies were sources of volatility. Changing expectations and domestic economic factors (such as the inflation record or volatility in the money market), however, did not appear to explain volatility.