Algorithmic trading has been accused of exacerbating volatility in the European interest rate market, which has experienced boxing match-like fluctuations.

Affected by the conflict in the Middle East, the volatility of the European interest rate market is expected to hit a record high this month, sparking discussions in the market about the role that algorithmic trading plays in exacerbating market turbulence. As a tool for betting on central bank policy prospects, the two-year euro interest rate swap experienced historic volatility in March, while a similar contract in the UK saw the most dramatic month of volatility since former Prime Minister Liz Truss stepped down in 2022. This market turmoil comes as the Iran war has disrupted market expectations for inflation and economic growth in Europe, leading traders to swiftly shift from betting on rate cuts to betting on rate hikes. However, the speed and magnitude of market volatility have led some fund managers to point out that artificial intelligence and algorithmic trading are playing a more important role than ever before. Advances in artificial intelligence have enhanced the market's ability to process evolving military situations and conflicting information shared by US and Iranian officials on social media. Craig Inge, head of rates and cash trading at Royal London Asset Management, compared the current market volatility to a boxing match. He said, "It does feel a bit like being punched in the head every day. The scales are definitely tilted towards faster, leveraged funds." In recent years, hedge funds using algorithmic models instead of human judgement for trading have become increasingly influential in bond and forex markets. These CTA funds typically increase positions during trend acceleration, but can quickly reverse course during momentum shifts (as seen this month). Before the conflict erupted, market trends were clear: the market expected a rate cut from the Bank of England, while the European Central Bank was expected to hold rates steady. Against this backdrop, coupled with low volatility, hedge funds used leverage to boost returns - and these positions were subsequently crushed by the market turmoil triggered by the war. Michael Schneider, head of cross-asset and macroquantitative strategies at BNP Paribas, said, "So far this year, CTA funds have experienced extreme volatility in the European government bond market." According to an investment bank, hedge funds traded twice as much in the European interest rate market this month as asset management companies, most of which remained on the sidelines. The bank requested anonymity due to rules regarding client data disclosure. Hamza Homadi, head of European interest rate trading at Barclays, stated in the bank's podcast that the use of powerful AI models enables the market to react quickly to news headlines, undoubtedly speeding up decision-making, "but I also believe that this poses a risk of increasing market volatility." Given Europe's reliance on energy imports, the region is highly susceptible to the consequences of the Middle East conflict. With both the ECB and Bank of England tasked with a single price stability mandate, they are particularly sensitive to inflationary pressures. The current challenge lies in the wide range of consequences the conflict may bring, and predicting how central banks will respond is particularly tricky, likely keeping volatility elevated in April. The market quickly priced in a shift to rate hikes by central banks, but if the energy price shock is short-lived, policymakers may choose to overlook its impact. This has prompted some fund management companies to adjust their trading strategies to cope with the current situation. Inge from Royal London Asset Management expects bonds to eventually rebound after the market drops this month, but he says that in such a high volatility environment, it's hard to hold long-term strategic positions. Instead, he is trying to become more flexible by locking in profits when the market rises and looking for opportunities to buy back in after sell-offs. On certain trading days this month, the daily trading ranges for German and British two-year bonds exceeded 25 basis points and 40 basis points, respectively, a level of volatility that had only occurred a few times before. Other long-term investors are choosing to seek refuge in less volatile market segments. For David Zahn, head of European fixed income at Franklin Templeton, this means holding German 30-year government bonds. The yield on these bonds rose by about 15 basis points this month, only a quarter of the increase seen in the more rate-sensitive two-year bonds. He said, "One of the reasons we hold German bonds is not because we think they will necessarily make us a lot of money, but because they are a very good diversification tool that helps stabilize the portfolio."