By David Absolon, Investment Director at Heartwood Investment Management

Last week's events in the global sovereign bond markets tell us that upward movements in yields are being amplified by declining liquidity, an issue that has been a concern of ours for some time.

Central bankers are warning investors to prepare for more turbulent times ahead, concerns most emphatically expressed by European Central Bank President Draghi in his press conference following the June monthly meeting.

Yet again the source of last week's sovereign bond market volatility was Germany. The 10-year German bund yield recorded its largest two-day move higher in yield since the formation of the euro currency bond market in 1998.

An evaporating deflation mind-set and the feeling that the ECB was not as dovish as previously thought were both rational reasons for yields to move higher. ECB rate hike expectations were brought forward by nearly a full year to the end of 2017; hitherto, it felt like some investors had become so complacent that they thought the ECB would never raise rates again!

But more surprising is the violence of the move in a triple A-rated sovereign bond market. After all, inflation in the eurozone is still only modestly above zero and growth remains relatively low.

Bull and Bear (PD)Initial indications of thinning liquidity were flagged in October 2014 when the 10-year US treasury yield went into a 30-basis-point free fall for a brief period before recovering quickly.  Liquidity conditions remain precarious. According to some reports, at the beginning of last year a trader could have traded up to 100 contracts of US 30-year German bund futures in one day without moving the market. That figure now stands at 20.

High frequency trading, decreased inventories of the market makers who are usually in place to supply liquidity, and elevated levels of public and private debt create the conditions for more bond market volatility going forward. Central bank quantitative-easing policies across the world also have unknown outcomes that may have deep consequences across markets. In the current environment, the ECB is usurping the Fed as the central bank to watch, most vividly brought to light by the global impact of Germany's bond market volatility over the last month.

Some of the reasoning for these global ramifications can be attributed to the carry trade. As bond yields collapsed in the eurozone and the euro weakened, investors looked to other bond and currency markets, including the US and UK, to exploit both interest rate and currency advantages. Therefore, the unwinding of these relative value trades magnifies the sell-off in yields across all major sovereign bond markets.

How should investors react in these markets? Our view remains one of charting a prudent course in bonds: less market weight and of shorter maturity, but selectively invested in less interest rate sensitive sectors, such as floating rate note bonds and certain value areas of the high yield sector, a market which incidentally fared well during last week's storm.

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