Phantom Markets Part 1: Why The TBAC Is Suddenly Very Worried About Market Liquidity
Perhaps the best source of real, actionable financial information, at least as sourced by Wall Street itself, comes in the form of the appendix to the quarterly Treasury Borrowing Advisory Committee (TBAC, aka the Goldman-JPM chaired supercommittee that really runs the world) presentation published as part of the Treasury's refunding data dump. These have informed us in the past about Goldman's view on floaters, as well as Credit Suisse's view on the massive and deteriorating shortage across "high quality collateral." This quarter was no different, only this time the indirect author of the TBAC's section on fixed-income market liquidity was none other than Citi's Matt King, whose style is well known to all who frequent these pages simply because we cover his reports consistently. The topic: liquidity. Or rather the absolute lack thereof, despite what the HFT lobby would like.
This is the first of two posts discussing the ongoing fears that the TBAC has vis-a-vis not only fixed income liquidity (of which it is very concerned indeed, and not only because of Jeremy Stein's Overheating in Credit Markets speech), but its overall views on how the past five years of Bernanke central-planning have impacted this critical component of functioning markets, or as well call them: phantom markets - which work until 1 millisecond after the HFT crew pushes the OFF button and all liquidity disappears.
In short: despite what various new "technology" lobbies, such as the HFT's, all of which are merely peddling legal millisecond frontrunning services, the TBAC's conclusion is the opposite: be afraid, be very afraid. Because just when you need liquidity it will be gone.
First, how does one define liquidity? Here is how the smartest guys in the room (and Matt King truly is one of the smartest guy) do:
As the chart points out, the biggest falacy constantly perpetuated by market naivists, that liquidity and volume (in this case in fixed income) are one and the same, is absolutely wrong. Of course, in equity markets it is far worse because while volumes are crashing, liquidity is far worse.
Another way of showing the structural impairment in the fixed income market as a result of the liquidity collapse (courtesy of Bernanke) - in times of smooth sailing, all is well. When vol returns, spikes soar as all liquidity is withdrawn.
And while liquidity in the primary bond issuance market is at a record, thanks to the Fed's backstop of the Primary Dealers who backstop every auction...
... things in the secondary market are getting worse by the day. In fact, the TBAC's (read, Matt King's) observation is that since the bulk of trading if concentrated in a few key uber liquid bonds (at the expense of the remainder of the market), a need for a risk warehouse has emerged. Who may fill that role, one wonders: the Fed perhaps (which in turn would make self-sustaining liquidity even more improbable and further destabilize the market).
The TBAC's conclusion: the longer central planning goes on, the less the actual large "block" trades, and even those are getting smaller.
The blue text above is self-explanatory: the slightest gust of wind, or rather volatility, threatens to shut down the secondary corporate bond market, which already is running on fumes.This can be seen in the final chart of this post which confirms that the Fed is succeeding... to its paradoxical chagrin! Because the more pure liquidity moves to the (Fed-backstopped) Treasury market, the more investors are moving away from the most liquid instruments.
In other words, while the Fed, and the TBAC, both lament the scarcity of quality collateral and liquidity in non-Fed backstopped security markets, it is the Fed's continued presence in the (TSY) market in the first place, that is making a mockery of bond market liquidity and quality collateral procurement. And without faith in a stable credit marketplace, there is no way that a credit-based instrument can ever truly become the much needed "high quality collateral" to displace the Fed's monthly injection of infinitely funigble and repoable reserves (most benefiting foreign banks).
At least until the shadow market itself locks up (which new leverage ratio regulations virtually guarantee will happen in the near future), and all bets are off.
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