Warns of Bond Market Blow Out With Liquidity Vanishing
By the Curmudgeon
This week the International Monetary Fund (IMF) highlighted a danger of the widely anticipated Fed rate hike: that investors will rush for the exits to escape falling bond prices.
In an interview with the Financial Times (on line subscription required) José Viñals, Director of the IMF’s monetary and capital markets department, warned of a “super taper tantrum” and spiking yields as the Fed gets nearer to lifting rates for the first time since 2006. “This is going to take place in uncharted territory,” he said.
In its Global Financial Stability Report, released on Wednesday April 15th, the IMF argued that risks have not only risen worldwide, but that they have rotated to parts of the financial world that are harder to monitor, including the non-bank sector.
Mainstream media largely ignored this report as they also ignore BIS warnings. Can you guess why?
The IMF report says there are “severe challenges” brewing in the EU life insurance sector amid plunging interest rates in the region (several European countries have negative interest rates). Many insurance policies are offering generous return guarantees that are “unsustainable” in a prolonged low-interest rate environment, the IMF warned, highlighting German and Swedish firms.
The IMF warned: “Without the buoyant liquidity provided by the Federal Reserve, the liquidity-inhibiting impact of regulatory changes, industry consolidation and other secular factors will probably become more pronounced.”
“Markets could be increasingly susceptible to episodes in which liquidity suddenly vanishes and volatility spikes,” the IMF report stated, pointing to episodes including the price gyrations seen in U.S. Treasury prices last October (a bond market flash crash).
Not everyone is worried. Futures pricing suggests investors are expecting a markedly slower lift-off than the Fed officials’ own projections. The Atlanta Fed's Dennis Lockhart said that if market and Fed expectations were badly out of whack it would indeed be a worry. However, he said the apparent gap between the so-called “dot plot” of policy makers’ rate predictions and the path implied by financial contracts partly reflected the different mechanisms at work.
U.S. Treasury Bond Market Not So Liquid!
Separately, a senior Fed official expressed concern about bond market liquidity. Simon Potter1, executive vice-president of the Federal Reserve Bank of New York, warned in a speech on Monday that the unintended consequences of regulatory and market changes could mean that "that sharp intraday price moves become more common" in the future.
1Simon Potter heads the New York Fed’s Markets Group
In a recent white paper on the increasing automation of trading in U.S. Treasuries, the New York Fed highlighted explanations including computer-driven high-frequency trading; poor economic news leading to investors swiftly reversing bets against Treasuries; and changing structures in the bond market. The paper stated that experts "have generally been unable to attribute the price action to any single factor."
"It is possible that changes in the participation or behavior of firms employing automated strategies — including broker-dealers and proprietary trading firms — had an effect on market liquidity and price movements that day," he said according to the transcript of his speech.
This was echoed by Mr. Potter in his speech to big banks that are the primary dealers in the U.S. Treasury market, but the Fed official attributed the speed of the moves at least partly to the rise of electronic, high-frequency trading in the U.S. government bond market.
Such concerns are warranted by the transformation of the U.S. Treasury bond market since the financial crisis. Dealers, who support the market and underwrite Treasury debt sales, have become smaller and are less willing to stem volatile changes in prices, reflecting tougher regulations and higher costs of capital. Astonishingly, the financial press or bubble talk CNBC never talk about this critical issue.
From the Fed's perspective, the onus is on dealers to support the bond market in times of turbulence. Simon Potter said the dealers should act as “good citizens." Good luck!
The dealers are very upset that the Fed’s hefty QE bond purchases removed several trillion dollars of Treasury debt from the fixed income market and hence harmed overall liquidity.
“There is no economic benefit in being a primary dealer at the moment, and why would you step in and support the market if that’s the case?” a New York interest rates trader told the FT.
“The liquidity situation does worry me,” said James Sarni, managing principal at Payden & Rygel. “The broker-dealer community does not have the willingness or ability to take the other side of bond trades,” he added.
Treasury Bond Market Composition:
The U.S. Treasury bond market has swollen markedly over the past decade, with Treasury debt tripling to $12.5 trillion with the Fed's balance sheet ballooning to over $4.2 trillion.
As a result, big bond buyers like sovereign wealth funds and large institutional investors, led by BlackRock and PIMCO, have become far more powerful in the U.S. fixed income universe.
Due to the suppression of interest rates by the Fed and foreign central banks, money has flooded into bond funds, driven by retiring baby boomers who may not be aware of the risks (i.e. a bond fund is NOT a CD!). There's been explosive growth in assets of fixed income mutual funds, ETFs and even closed end funds.
Foreign demand for U.S. debt has grown sharply, with Japan and China owning $1.2 trillion each of U.S. Treasury securities.'
According to recent research from Michael Gavin of Barclays, baby boomer savings could account for about 2% points of the decline in the “natural” real interest rates — adjusted for inflation and the economic cycle — over the past three decades, from about 2% in the 1980s to roughly zero or negative today. However, this will soon change. Western baby boomers have started retiring and in the coming years will draw down their savings, as the number of working-age people declines. That will produce less demand for bonds and notes.
Market Obsession with the Fed:
This one-way traffic into U.S. Treasury bonds and notes by large institutional investors has been overshadowed by the Fed’s efforts to normalize interest rates in the coming year. Every financial pundit hangs on each word in the Fed meeting minutes or in a speech by Fed Chairwoman Janet Yellen.
The Curmudgeon believes this obsession with the next Fed rate rise (first in 9 years) has dominated over conventional forms of investment and asset allocation criteria and is very unhealthy for financial markets.
Robert McAdie, head of research and strategy at BNP Paribas, says a poorly conceived signal from the Fed could trigger a “serious effect” in markets. “Due to illiquidity you could see severe moves and losses that could spiral,” he says. “These volatility spikes make it harder to manage risks. This is a problem that is here to stay.”
Erik Weisman, portfolio manager at MFS Investment Management, says 10 or 20 years ago the banking sector was capable of collectively acting as a “good citizen” and warehousing some debt in the hope of slowing a market decline and allowing cooler heads to prevail in a panic. “The ability of banks to do that today seems far more limited,” he said.
Till next time...
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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