The Liquidity Time Bomb?
A paradox has emerged in the financial markets of the advanced economies since the 2008 global financial crisis. Unconventional monetary policies have created a massive overhang of liquidity. But a series of recent shocks suggests that macro liquidity has become linked with severe market illiquidity.Roubini isn't the only one warning of the perils of lack of market liquidity:
Policy interest rates are near zero (and sometimes below it) in most advanced economies, and the monetary base (money created by central banks in the form of cash and liquid commercial-bank reserves) has soared – doubling, tripling, and, in the United States, quadrupling relative to the pre-crisis period. This has kept short- and long-term interest rates low (and even negative in some cases, such as Europe and Japan), reduced the volatility of bond markets, and lifted many asset prices (including equities, real estate, and fixed-income private- and public-sector bonds).
And yet investors have reason to be concerned. Their fears started with the “flash crash” of May 2010, when, in a matter of 30 minutes, major US stock indices fell by almost 10%, before recovering rapidly. Then came the “taper tantrum” in the spring of 2013, when US long-term interest rates shot up by 100 basis points after then-Fed Chairman Ben Bernanke hinted at an end to the Fed’s monthly purchases of long-term securities.
Likewise, in October 2014, US Treasury yields plummeted by almost 40 basis points in minutes, which statisticians argue should occur only once in three billion years. The latest episode came just last month, when, in the space of a few days, ten-year German bond yields went from five basis points to almost 80.
These events have fueled fears that, even very deep and liquid markets – such as US stocks and government bonds in the US and Germany – may not be liquid enough. So what accounts for the combination of macro liquidity and market illiquidity?
For starters, in equity markets, high-frequency traders (HFTs), who use algorithmic computer programs to follow market trends, account for a larger share of transactions. This creates, no surprise, herding behavior. Indeed, trading in the US nowadays is concentrated at the beginning and the last hour of the trading day, when HFTs are most active; for the rest of the day, markets are illiquid, with few transactions.
A second cause lies in the fact that fixed-income assets – such as government, corporate, and emerging-market bonds – are not traded in more liquid exchanges, as stocks are. Instead, they are traded mostly over the counter in illiquid markets.
Third, not only is fixed income more illiquid, but now most of these instruments – which have grown enormously in number, owing to the mushrooming issuance of private and public debts before and after the financial crisis – are held in open-ended funds that allow investors to exit overnight. Imagine a bank that invests in illiquid assets but allows depositors to redeem their cash overnight: if a run on these funds occurs, the need to sell the illiquid assets can push their price very low very fast, in what is effectively a fire sale.
Fourth, before the 2008 crisis, banks were market makers in fixed-income instruments. They held large inventories of these assets, thus providing liquidity and smoothing excess price volatility. But, with new regulations punishing such trading (via higher capital charges), banks and other financial institutions have reduced their market-making activity. So, in times of surprise that move bond prices and yields, the banks are not present to act as stabilizers.
In short, though central banks’ creation of macro liquidity may keep bond yields low and reduce volatility, it has also led to crowded trades (herding on market trends, exacerbated by HFTs) and more investment in illiquid bond funds, while tighter regulation means that market makers are missing in action.
As a result, when surprises occur – for example, the Fed signals an earlier-than-expected exit from zero interest rates, oil prices spike, or eurozone growth starts to pick up – the re-rating of stocks and especially bonds can be abrupt and dramatic: everyone caught in the same crowded trades needs to get out fast. Herding in the opposite direction occurs, but, because many investments are in illiquid funds and the traditional market makers who smoothed volatility are nowhere to be found, the sellers are forced into fire sales.
This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into overvalued, increasingly illiquid assets – such as bonds – the risk of a long-term crash increases.
This is the paradoxical result of the policy response to the financial crisis. Macro liquidity is feeding booms and bubbles; but market illiquidity will eventually trigger a bust and collapse.
Accumen Management director Ken Veksler wrote a couple of months ago about how liquidity has been drying up, particularly in FX. Former US Treasury Secretary Larry Summers and JPMorgan Chase boss Jamie Dimon both agree.And Wes Goodman of Bloomberg reports, Gross Says Bond Rout Scary as Hell Even Without Bear Market:
European Central Bank board member Benoit Coeure has also expressed concern about the lack of liquidity driving volatile movements in bond markets recently.
Treasury prices are falling enough to spook even market veteran Bill Gross.
The turmoil has sent U.S. government securities maturing in 10 years and longer down 7.4 percent since the end of March, heading for the biggest quarterly loss since 2010, based on Bloomberg World Bond Indexes. The decline is part of a global selloff, led by German bunds and fueled by what traders say is a lack of liquidity.
“I recognize the tremendous liquidity problems and the ups and the downs on a daily basis -- or even on a minute basis -- and it scares the hell out of me,” Gross said in an interview Thursday. “But I don’t think we’re in for a bear bond market just yet.”
Gross, who runs the Janus Global Unconstrained Bond Fund and is the former manager of the Pimco Total Return Fund, also said Treasuries have fallen to fair levels. He co-founded Pacific Investment Management Co. in 1971, according to the Janus website.
The benchmark Treasury 10-year yield rose three basis points, or 0.03 percentage point, to 2.34 percent at 6:56 a.m. New York time, according to Bloomberg Bond Trader data. It reached 2.42 percent on Thursday, the highest since October, having climbed from a year-to-date low of 1.64 percent.
Gross said 2.30 percent is “fair value.”
Volatile Market
Treasury market volatility climbed to a three-month high this week, according to the Bank of America Merrill Lynch MOVE Index. The gauge increased to 91.81 Wednesday, from as low as 70.99 on April 27.
“People’s faces are within inches of their screens, eyes are glued to the screens, to the news sources, to the price action,” said Craig Collins, managing director of rates trading at Bank of Montreal in London. “You see the market move and it’s ‘what’s out, what’s out?’ Risk appetite is very, very low with the liquidity in the market being very low and that’s made for this really choppy price action.”
Trading activity is declining because of regulations such as the Volcker Rule and Basel III that require banks to cut back on risky activities and holdings, according to Hajime Nagata, who invests in Treasuries for Tokyo-based Diam Co. Bond-market moves have become exaggerated as a result, he said.
The primary dealers that underwrite America’s bonds have cut U.S. government debt holdings to $30.3 billion as of May 27, from a record $146 billion in October 2013, Federal Reserve data show.
Trader Cutbacks
JPMorgan Chase & Co., Morgan Stanley, Credit Suisse Group AG and Royal Bank of Scotland Group Plc have all either cut back their fixed-income trading desks in the past year, or are considering reductions in those businesses.
Central bank bond purchases are adding to the pressure by reducing the available supply.
The European Central Bank and Bank of Japan are both snapping up record amounts of government debt as they try to spur their economies. The ECB increased its purchases in May ahead of the region’s summer vacation period. The Federal Reserve’s Treasury holdings are near a record after it concluded its own bond-buying program last year.
Even with ECB buying, German 10-year yields climbed to 0.996 percent Thursday from the record low of 0.049 percent set in April.
No Bear MarketIndeed, this week's quick spike in bond yields may be over for now but some strategists warn a higher level of volatility is here to stay:
Gross said he doesn’t see the threat of a bear market in bonds with inflation falling short of the Fed’s 2 percent target. The central bank’s preferred measure of costs was 0.1 percent as of the most recent report in April.
A period when returns aren’t positive is generally considered a bear market in bonds. While securities with the longest maturities have suffered the brunt of the global selloff, other debt investments fared better.
The Vanguard Total Bond Market Index Fund, the biggest bond mutual fund in the world with $118 billion in assets, is little changed this year, according to data compiled by Bloomberg. It’s returned 2.6 percent over the past 12 months.
The debt-market selloff probably doesn’t have much further to go, said Peter Jolly, the Sydney-based head of market research at National Australia Bank Ltd.
“It’s been violent, and it’s happened in a short few days,” Jolly said. “We’re getting to the point where some investors are starting to see value in buying bonds again.”
A grueling bond market rout, led by the German bund, drove interest rates to eight-month highs and yields could now trade at a new higher range. While rates could continue to rise more gradually strategists say this rapid jump may have topped out temporarily. The 10-year reached a high of 2.42 percent Thursday before slipping back to 2.33 percent.
Strategists said the selling appeared to reverse when the German 10-year yield hit 1 percent earlier Thursday. Buyers also came in when the International Monetary Fund said that the U.S. should delay Fed interest rate hikes until next year.
"The price action is keeping people to the sidelines, confused and very anxious," said David Ader, chief Treasury strategist at CRT Capital. "You get to a level, and we stop selling off. Some buying comes in and all of a sudden, the selling stops and you go the other way."
U.S. 10-year Treasury yield
Ader said it appears yields are topping out for now and he expects the 10-year to trade in a range of 2 to 2.5 percent over the course of the summer.So is the scary bond market about to get scarier? Is the "bigger short" already here? Is it time to prepare for global reflation and an unexpected surge in U.S. inflation?
"We had an almost 1 percent bund, and we just bounced," said Justin Lederer, rates strategist at Cantor Fitzgerald. "Between that and the IMF headlines about delaying a first rate hike to Quarter 1, the Treasury market has found some life and is trading extremely well. We haven't reached yesterday's levels and we're still down for the week but this is a better place to go into payrolls. It's been a feast or famine market."
Markets have been looking forward to May's employment data Friday for what it will say about labor slack and wages, important elements in Fed decision-making. A total of 225,000 jobs are expected, and the unemployment rate is projected to stay steady at 5.4 percent. Average hourly wages are expected to rise 0.2 percent.
Lederer said there may not be a big move in yields Friday, even if the number is better or worse than expected. Instead, a better number may cause the yield curve to flatten, meaning the short end yields rise faster than the long end, which have been most affected by German rates. That would be a sign that the market expects a Fed rate increase sooner rather than later.
The U.S. Treasury market has been tethered to Europe, as the European Central Bank earlier this year committed to an easy money policy, the opposite direction U.S. central bankers are expected to take. In contrast, U.S. Treasurys were higher yielding and relatively more attractive, so when Europe sold off, the U.S. went with it.
"The way things are now, everyone is in the same trade so ultimately when everyone was thinking the bund (yield) was going negative, everyone was long bunds and when it goes the other way, it's not a pretty trade," said Lederer.
Traders say the rapid move in the U.S. market shows a detachment from fundamentals, and the move in Treasurys itself could take on a life of its own.
European yields shot up Wednesday, in part on an improving economy but also because ECB President Mario Draghi in comments Wednesday made no commitment to tame European rates.
Bank of America Merrill Lynch strategists said in a note Thursday that they believe the yields on 10-year bunds and Treasurys were topping out, and that they are now bullish.
On Wednesday, the strategists said the bund yield could be getting close to a top on a technical basis, as were U.S. 10-year note yields. They said the U.S. 10-year yield could move deeper into the 2.366/2.429 percent range before falling back to a range between 1.957 and 2.161 percent.
They said Thursday that the move to 2.252 percent confirmed the topping out move.
The short answer is no. There was a global bond rout this week, likely exacerbated by the lack of market liquidity and many trades were "too crowded," but the fact remains that in the titanic battle of deflation vs inflation, the former is still winning.
And as long as global deflation looms large, I wouldn't get all flustered about any spike in global bond yields. In fact, most pension funds and other institutions closely matching assets with liabilities are going to be jumping on the opportunity to buy bonds as yields back up and prices fall.
Go back to read my analysis of Ontario Teachers' 2014 results where its CEO Ron Mock explained that bonds serve three functions: 1) they provide a negative correlation to stocks; 2) they provide return and 3) they move opposite to their liabilities. "If rates go up, our liabilities decline by a lot more than the value of our bond portfolio, which is exactly what we want to maintain the plan fully funded."
Keep Ron's comments in mind because from a pension plan's perspective, the rise in bond yields is good because it lowers the future liabilities of the plan.
Unfortunately, I don't think rates are going much higher and there is reason to believe they might even head much lower. First, while U.S. job growth accelerated sharply in May and wages picked up, I don't agree that this bolsters prospects for an interest rate hike in September.
Why? Because the annual increase in hourly average wages is temporary and not sustainable. More importantly, a broad measure of joblessness that includes people who want to work but have given up searching and those working part-time because they cannot find full-time employment was unchanged at 10.8 percent (look up the concept of hysteresis in economics).
Second, the world isn't exactly prepared for a major shift in Fed policy. Greece missed its IMF payment in a warning shot to its creditors and while some think a deal will be reached that will avoid default and Grexit, the standoff with creditors can explode at any time, especially if snap elections are called.
More worrisome, in his latest comment on Project Syndicate, Europe's Last Act?, Joe Stiglitz warns that this 'game of brinkmanship' with the Greek government, asking them to sign on to increasingly unacceptable terms (like jacking up taxes when the country is in a debt deflation spiral!!), is insane and it won't end well for all parties.
Moreover, Stiglitz rightly notes the following:
Some in Europe, especially in Germany, seem nonchalant about a Greek exit from the eurozone. The market has, they claim, already “priced in” such a rupture. Some even suggest that it would be good for the monetary union.People who underestimate the risks of contagion from a Grexit scenario are living in Fantasyland. I guarantee you that central banks around the world, including the Fed, are looking very closely at geopolitical developments in Greece and elsewhere.
I believe that such views significantly underestimate both the current and future risks involved. A similar degree of complacency was evident in the United States before the collapse of Lehman Brothers in September 2008. The fragility of America’s banks had been known for a long time – at least since the bankruptcy of Bear Stearns the previous March. Yet, given the lack of transparency (owing in part to weak regulation), both markets and policymakers did not fully appreciate the linkages among financial institutions.
Indeed, the world’s financial system is still feeling the aftershocks of the Lehman collapse. And banks remain non-transparent, and thus at risk. We still don’t know the full extent of linkages among financial institutions, including those arising from non-transparent derivatives and credit default swaps.
As I've stated many times in this blog, this time is really different and if the Fed ignores international developments and starts raising rates too soon, it will be making a monumental mistake, igniting a liquidity time bomb and a crash unlike anything we've ever experienced before.
All this to say that too many market participants glued on their Bloomberg terminal need to take a step back and think more carefully about the world and the real risks that lie ahead.
I attended an AIMA luncheon on market volatility yesterday which included great insights on sources of volatility and how to address them. I don't have time to cover it here but I promise to follow up on it next week and might even share with you some of my "superpowers" (like exercising enormous self-restraint when my question on deflation vs inflation is rudely dismissed by my former boss at the Caisse. -:) ) .
On that note, I wish you all a great weekend and please remember to donate and/ or subscribe to this blog via PayPal on the top right-hand side. You'd be surprised who subscribes to my blog, some very nice and smart heavy hitters in the pension industry who respect my contributions and think I deserve to get properly compensated for all my hard work. I wish more leaders would follow their lead.
Below, CNBC's Rick Santelli speaks to two of my favorite market commentators, Jeffrey Gundlach, Doubleline Capital CEO, and Jim Bianco, Bianco Research president, about higher rates and the impact to bond prices and stocks.
Gundlach thinks the Fed won't raise rates this year and warns that junk bonds are very vulnerable to a rise in rates. If rates eventually start rising, triggering a liquidity time bomb, the high yield and corporate bond market will get clobbered, decimating many institutional and retail investors. Listen carefully to the discussion below, it's truly excellent and provides great insights on the risks ahead.
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