Piecing together the October 15 puzzle

Huge US Treasury swing was result of hedge funds crowding into a few shared bets - on oil, pharma merger, Fannie and Freddie shares

On October 15, the yield on the 10-year US Treasury bond fell 34 basis points in a matter of hours before rebounding, taking a huge, V-shaped bite out of the day's yield chart. Nothing like it had happened since the collapse of Lehman Brothers in 2008 and, before that, there were whole decades in which a 10bp intraday move would have been fairly dramatic.

The worrying thing was that it occurred in the absence of a Lehman-like cataclysm, or anything else that would obviously cause the world's most liquid security to behave like a penny stock. So why did it happen?

As it turns out, the answer is pretty simple – but putting it together meant speaking to 24 dealers, funds and other market participants, each of which had a piece or two of the puzzle.

In short, hedge funds had crowded into the same series of bets and were forced to cut risk massively after suffering heavy losses. For some, the trigger was unexpectedly weak US retail sales, forcing them to cover long-running and spectacularly unsuccessful US growth/short rates trades; for others, the trigger was the death of a proposed pharmaceutical merger between AbbVie and Shire, which fell apart after markets closed on October 14.

A number of funds had been convinced the latter trade would pay off. Paulson & Co had positions amounting to just less than 10% of its total assets; at least four others had 4% or more of their assets sunk into Shire stock. Analysis conducted for Risk by Novus Partners suggests funds had $5.8 billion of net exposure to the deal and saw losses of $1.82 billion when Shire stock fell 30% on October 15.

Others say the funds’ problems would have made the market fragile, but insist there must have been another element – a sudden mushrooming of short gamma exposures

Does that explain a massive flight to the safety of the US Treasury market? For some market participants, yes. Others say the funds' problems would have made the market fragile, but insist there must have been another element – a sudden mushrooming of short gamma exposures in the dealer community, which would help explain not just why yields tightened massively, but also why they sprang back out.

The next question is whether this could happen again. As with most big market moves, it looks in retrospect like a mix of bad luck and bad judgement – there is nothing new here. The newer element is a structural change in market liquidity. This will not, on its own, cause a future meltdown, but it could amplify it.

As the chief executive of Novus says: "The ability of hedge funds to liquidate their portfolios has decreased over time due to greater crowding and herding behaviour. The critical point is that managers don't appreciate this new hidden risk. They're looking at their own books and calculating their liquidity as if they would be the only ones selling. They're not thinking about the huge number of other managers that are in the exact same security."