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US Treasury Warns Investors Underestimate "Potential For A Market Reversal", Take "Low Volatility For Granted"

Tyler Durden's picture




 

It was about a year ago when, in its inaugural annual report, the Treasury's Office of Financial Research issued its first tentative warning about the lack of market liquidity. To wit: "Impaired trading liquidity — the inability to execute large trades without having a significant impact on market prices — could aggravate some of the threats already discussed... Liquidity has become increasingly concentrated, with large, investment-grade bonds showing the strongest liquidity, while some smaller, high-yield issues have become less liquid... The growth in exchange-traded funds within the corporate bond market increases the potential to weaken market liquidity during periods of market stress."

Amusingly enough, as the WSJ reminds us, the OFR office came under fire for that report "pointing to vulnerabilities in the asset-management industry, a step that was viewed as a precursor to further regulation of that sector. Other U.S. regulators haven’t taken steps since then that would indicate they are reacting to the report with new regulations, although Tuesday’s report outlined some potential concerns if regulators do decide to act. Among them were derivatives that increase borrowing by asset managers and exchange-traded funds that invest in bank loans."

In any event, not even the OFR warned that one key market that could be massively impaired by lack of liquidity, is the US Treasury bond market itself, something we cautioned about in 2012 and 2013, and which became a screaming issue on October 15 when the entire US bond market flash crashed for a few seconds for reasons still largely unknown.

So just to make sure the Treasury has fully completed its pre-crash CYA protocol, and is covered when the next Treasury flash crash does take place (it is unclear if it sends prices higher or lower, and at this point in the centrally-planned, broken market it doesn't matter - all that matters is when the CBs finally lose control in either direction), here is the latest warning from the US Treasury about the biggest unintended consequences of 6 years of central bank QE (one we warned about again and again and again and so on): the complete disappearance of market - any market - liquidity. Oh that, and also this: investors may have taken low volatility for granted and underestimated the potential for a reversal."

But did they overestimate the potential for James Bullard showing up right on cue when the S&P enters a 10% correction and screams loudly to the algos that QE4 is just around the corner? 

Didn't think so.

From the OFR's 2014 Annual Report:

Review of 2014 Market Developments

 

Following a prolonged period of calm, investors’ concerns about extended valuations and global economic growth triggered a broad-based reassessment of risk in September and October 2014. Global risky assets sold off, volatility spiked, and global sovereign bond yields fell amid a flight to safety. Measures of tail risk — the risk of extremely rare events — also increased, as demonstrated by demand for protection against adverse future moves in market prices. The dislocation was large and unexpected, but short-lived. Expectations for continued monetary policy accommodation helped asset prices stabilize and partially recover. But investor sentiment remains fragile.

 

The episode revealed a number of underlying vulnerabilities. First, during a protracted period of low interest rates and the Federal Reserve’s quantitative easing, investors may have taken low volatility for granted and underestimated the potential for a reversal. While quantitative easing policies are intended to encourage investors to buy risky assets, there is also a risk that the perceived reversal of such policies will lead investors to turn the other way, triggering market instability.

 

Similarly, investors may have become too sanguine about the availability of market liquidity — the ability to transact in size without having a significant impact on price — during both good times and bad. While structural changes in the provision of market liquidity are not fully understood, financial stability analyses in recent years, including the OFR’s previous annual reports, have noted the potential fragility of market liquidity during a market shock, due in part to the reduced willingness or capacity of broker-dealers to provide liquidity (see OFR, 2013a; IMF, 2014c; and Market Liquidity Risks in Section 2.3). The recent market dislocation showed those concerns to be valid, as market liquidity quickly vanished in traditionally liquid markets such as U.S. Treasuries, cash, and futures markets, leading to less market depth and further sharp price declines. (Reduced market depth increases the transaction cost of executing a trade in reasonable size.)

 

The liquidity strains in the U.S. Treasury market spread quickly to other markets, affecting related asset classes such as interest rate futures, swaps, and options to differing degrees. A liquidation of speculative short positions in interest rate markets also contributed to the instability. Anecdotally, some of the price movements appeared continuous, suggesting that a high volume of transactions was executed by algorithmic trading systems.

 

Although the dislocation that peaked in mid-October was fleeting, we believe there is a risk of a repeat occurrence, given the increased prevalence of algorithmic trading, a shift in risk preferences by broker-dealers, and the persistent incentives for risk-taking. The potential for a rapid and severe adjustment in prices followed by a reversal in derivatives markets or fixed-income markets — which are large, interconnected, and widely used for hedging and risk management — raises a host of financial stability concerns.

And the punchline:

Despite the market gyrations, overall demand for risky assets has not abated. Investors continue to be rewarded for taking credit, duration, and liquidity risk. Even after taking into account the broad-based market dislocation that occurred in September and October, higher risk assets such as eurozone peripheral bonds, emerging market sovereign and corporate debt, and U.S. corporate bonds remain among the better performing assets this year.

Yes, thank you Jim Bullard, Fed, BOJ, and ECB... something which even the Treasury admits:

Accommodative global monetary policy, coupled with the Federal Reserve’s purchases of large amounts of low-risk assets and changes in risk sentiment, helped to compress volatility and risk premiums. These conditions encouraged investors to increase their holdings of long-dated securities and products with riskier credit attributes in a search for higher returns. Over the past five years, investors moved out of money market instruments and into riskier assets such as leveraged loans, high-yield corporate credit, eurozone peripheral bonds, and emerging market equities.

 

During the recent bout of volatility, investors partly unwound their positions in eurozone peripheral credits, U.S. equities, and high-yield and leveraged loans. But the liquidation was not enough to offset the extended long positions that investors had built up over the past few years. On the contrary, the fleeting nature of the episode ultimately had the effect of reinforcing demand for duration, credit, and liquidity risk, and led many investors to reestablish such positions.

That, ladies and gents, is as close as the US Treasury will ever admit that the Fed has blown the world's biggest asset bubble in history.

 

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Thu, 12/04/2014 - 14:29 | 5517312 Theta_Burn
Theta_Burn's picture

 Bull ish?

Thu, 12/04/2014 - 14:32 | 5517326 kliguy38
kliguy38's picture

Muppet basting

Thu, 12/04/2014 - 14:42 | 5517364 KnuckleDragger-X
KnuckleDragger-X's picture

Nothing better than fresh roast muppet......

Thu, 12/04/2014 - 14:52 | 5517392 spastic_colon
spastic_colon's picture

so low rates + low lquidity + stock buybacks + volatility = blame "investors" when central banks start selling

Thu, 12/04/2014 - 14:53 | 5517394 WhyDoesItHurtWh...
WhyDoesItHurtWhen iPee's picture

C'mon guys ........  We reversaled some folks.

Thu, 12/04/2014 - 15:30 | 5517554 KnuckleDragger-X
KnuckleDragger-X's picture

I assume you mean in the porn sense....

Thu, 12/04/2014 - 14:38 | 5517350 venturen
venturen's picture

you left the "t" off and mixed up the letters

Thu, 12/04/2014 - 14:30 | 5517313 williambanzai7
williambanzai7's picture

Big talk...

Thu, 12/04/2014 - 15:07 | 5517454 Bluntly Put
Bluntly Put's picture

We jawboned some folks.

.

Thu, 12/04/2014 - 16:47 | 5517939 joego1
joego1's picture

Hey Mr. Lew we have bad news for you, you have a baby squid growing in your bowels...

Thu, 12/04/2014 - 14:30 | 5517316 pods
pods's picture

And remember to buy some T's on your way out, we are counting on it.

-US Treasury

Thu, 12/04/2014 - 14:30 | 5517321 kaiserhoff
kaiserhoff's picture

So Lew is starting to piss his pants, and trying to get some distance from the Fed?

  Good luck with that.

Thu, 12/04/2014 - 14:34 | 5517337 i_call_you_my_base
i_call_you_my_base's picture

The general population of the US doesn't even know what the fed is. Anything that happens will fall squarely on the current government (the president and congress). No one else will be blamed.

Thu, 12/04/2014 - 14:43 | 5517367 Bemused Observer
Bemused Observer's picture

Too bad our politicians are too stupid to see that. They support the system because it enriches them, but when the whole Ponzi collapses, THEY will be blamed because no one can understand the complexities of all the market shenanigans, there are too many moving parts to keep track of.
But elected leaders are an EASY target. And it is they who will get it full in the chest.

Thu, 12/04/2014 - 15:25 | 5517531 romanko
romanko's picture

I’d add that economics and finance aren’t necessarily complex fields.  We’re not talking nuclear physics complex. Whatever complexity exists is by design, to provide cover for fraud and to conceal the truth.

Thu, 12/04/2014 - 14:40 | 5517352 Bill of Rights
Bill of Rights's picture

Some folks just need Depends...

Thu, 12/04/2014 - 14:44 | 5517371 KnuckleDragger-X
KnuckleDragger-X's picture

Lew is trying to wipe his fingerprints off the coming disaster but he's still bent over and spread wide for the FED.

Thu, 12/04/2014 - 16:46 | 5517936 joego1
joego1's picture

The fed didn't order up a guy named Lew for nothin.

Thu, 12/04/2014 - 17:41 | 5518128 daveO
daveO's picture

It sounds like the FED's serious on raising rates, and warned the Treasury. Desperate to save the Petro Dollar, I guess.  

Thu, 12/04/2014 - 14:33 | 5517328 kowalli
kowalli's picture

USA clearly want to start ww3 between NATO and Russia

Thu, 12/04/2014 - 14:38 | 5517344 Glass Seagull
Glass Seagull's picture

 

 

Treasury:  "Lord, give me chaste...just...not...yehhhhhhhhtttttttttttttuhhhhhhhhhhhh."

Thu, 12/04/2014 - 14:39 | 5517345 buzzsaw99
buzzsaw99's picture

FUCKING HAHAHAHAHAHAHAHA!!!

FUCKING LIARS!!!!!!!!!!!!!!!!!!!!!!!!

Thu, 12/04/2014 - 14:37 | 5517346 Tsar Pointless
Tsar Pointless's picture

I didn't know The Onion took over operations at the US Department of the Treasury. Interesting.

Thu, 12/04/2014 - 14:40 | 5517351 venturen
venturen's picture

There is only one way...up forever!

Thu, 12/04/2014 - 14:40 | 5517354 order66
order66's picture

U.S. Stocks are undervalued. Every day. Infinity.

Thu, 12/04/2014 - 14:43 | 5517366 buzzsaw99
buzzsaw99's picture

TRANSLATION: THERE IS NO MARKET, THERE IS ONLY THE FED

Thu, 12/04/2014 - 15:08 | 5517465 ivana
ivana's picture

Get ready tommorow for gold/miners smackdown !

Thu, 12/04/2014 - 15:13 | 5517475 Dr. Engali
Dr. Engali's picture

Like I've said in the past, when this thing finally gives up the ghost it will happen so fast nobody save the few select insiders will know what happened.

Thu, 12/04/2014 - 15:15 | 5517485 FreeShitter
FreeShitter's picture

Thats why I have been long on hot pussy lately...its coming to an end.

Thu, 12/04/2014 - 15:44 | 5517634 JayKitsap
JayKitsap's picture

In January I am going to go "invest" in China courtesy of a really hot Chinese Tour Guide.

If I am going to get screwed I might as well enjoy it.

 

 

Thu, 12/04/2014 - 16:56 | 5517976 joego1
joego1's picture

The algos will have to do a lot of math on 0 really fast.

Thu, 12/04/2014 - 15:31 | 5517552 Bryan
Bryan's picture

I have a solution:  "raise interest rates."  Oh... what do you mean you can't?

Thu, 12/04/2014 - 15:42 | 5517630 ivana
ivana's picture

Ending expanding diagonals & double tops in EU & USA. General decline starts tommorow or on Monday

Thu, 12/04/2014 - 15:45 | 5517648 JayKitsap
JayKitsap's picture

What happens when the fed owns the whole market?

Thu, 12/04/2014 - 16:55 | 5517973 joego1
joego1's picture

We flip the board over and throw a fit.

Thu, 12/04/2014 - 16:58 | 5517983 LawsofPhysics
LawsofPhysics's picture

LOL!!!!  So, we are back to the hostage scene from "Blazing Saddles" I see.

 

Go ahead raise rates motherfucker, I triple dog dare you.

Thu, 12/04/2014 - 17:22 | 5518066 yogibear
yogibear's picture

Talking out of both side of their mouth.

If the market goes down just a bit you have the Federal Reserve doing a dog and pony show and talk about QE4.

Seems like the Fed wants the market to keep breaking records. 

 

Thu, 12/04/2014 - 21:01 | 5518663 theyjustcantstop
theyjustcantstop's picture

bar-keep, myra's all around.

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