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Drowning In Liquidity But None In The Bond Market: The Spark Of The Next Financial Crisis?

Tyler Durden's picture




 

Of all the themes we’ve been pounding the table on of late, the idea that a lack of liquidity in certain markets will eventually lead to an “accident” or “adverse event” (to use the Center for Financial Stability’s words) is perhaps the most pressing because with the Mario Draghis and Haruhiko Kurodas of the world intent on monetizing every bit of government paper they can get their hands on, “outlier” events such as the Treasury flash crash that occurred last October are likely to become far less outlier-ish as central banks discover that depriving the market of anything that even approximates high quality collateral can have a rather nasty destabilizing effect in a pinch. Two weeks back, we summarized the situation as follows: 

As central banks work to monetize all net (and sometimes gross) government bond issuance in their respective jurisdictions, QE is destabilizing markets by sapping liquidity which in turn inhibits price discovery and creates volatility. This is on display in Japan, where 2 out of 3 dealers think the JGB market is impaired thanks to BoJ asset purchases and where many officials are beginning to get more vocal about the possibility that a lack of liquidity could have “dire consequences.” Similarly, market financing via shadow banking conduits has declined by nearly half since 2008 in the US, and with dealers unwilling to hold inventory of corporate paper thanks to tougher capital requirements, the stage is set for what the Center for Financial Stability recently called “an accident.” Here’s what  the SEC's Daniel Gallagher had to say recently about liquidity in the US corporate bond market (via Bloomberg): "Lack of liquidity in corporate bond market is 'systemic risk' not addressed by regulators, SEC Commissioner Daniel Gallagher says in public remarks. Gallagher cites 80% decline in corporate bond inventories among dealers and impact of higher interest rates on future trading needs; 'that has accompanied a record level of issuance year after year since 2008 of $1 trillion-plus of corporate debt.'"

Building on this theme, we went on to highlight a UBS note which analyzed Fed rate hiking cycles for clues as to what the market should expect in terms of corporate spreads if and when a “diminutive” Janet Yellen decides to go ahead with a “liftoff.” What UBS found was rather disconcerting: 

Historical parallels and correlations of spreads to shifts in monetary policy expectations can find environments where Fed tightening equates to spread widening. But aside from the direct linkages of rates to spreads, a more fundamental concept is at play. The economic cycle and asset price cycle have diverged, with asset prices looking more like 1999 than either 1994 or 2004...

 

...the late 1990s and late 1960s demonstrate that a higher Fed Funds can lead to wider spreads in the context of a strong economy, high asset prices, and a lengthened economic cycle.

 

The key takeaway is that recent short-term shifts in monetary policy alter risk premia more than expectations of credit fundamentals, leading to positive correlation spikes. The current divergence between market implied pricing of Fed Funds vs. Federal Reserve forecasts is then a clear risk for credit investors. A Fed that is more aggressive with respect to the pace of tightening will re-price credit spreads wider.

Here’s the visual: 

All of this led us to wonder if in fact credit market carnage lies ahead: 

We are left to wonder what happens in the event UBS is correct and a Fed rate hike triggers widening corporate credit spreads in a corporate bond market devoid of liquidity. Could it indeed be the case that the Fed’s highly anticipated “lift-off” will serve as the catalyst for credit market carnage? 

It now appears some market participants indeed agree with our assessment. As The Telegraph reports

Investors across corporate bond markets are finding it harder to buy and sell company debt. And some investors are beginning to fear that the lack of liquidity will be the spark that ignites the next crisis in financial markets.

 

Liquidity is generally taken to mean the ease with which an investor can quickly buy or sell a security without moving its price. As regulation of banks tightens, the liquidity, particularly of European and US credit markets, has evaporated, prompting a host of regulators and central banks to sound warnings about the difficult trading environment.

 

A rate hike by the US Federal Reserve, which would be the first since 2006, could trigger turmoil. Given the bond market is much larger than the equity market, and investors have piled into fixed income in recent years, fears are growing that when credit investors attempt to sell bonds en masse, the illiquidity in the market has the potential to cause a crisis of a similar magnitude to the credit crunch.

We concur and we would also like to take this opportunity to point out that this is a shining example of how a number of the “New Paranormal” themes we’ve been discussing of late all fit together. A worldwide effort to resurrect a global financial system dying of leverage-related injuries and a global economy teetering on deflation ended up centering on the wholesale purchase of bonds, which in turn drove down borrowing costs and simultaneously sapped liquidity. Corporates, lured by rock-bottom rates, began borrowing in record amounts even as new regulations aimed at promoting stability ended up discouraging banks from serving their traditional role as middlemen, causing liquidity in the secondary market to evaporate just as companies began issuing a record amount of debt. Meanwhile, HY rates began to look more like IG rates thanks to central bank largesse, which had the unfortunate effect of allowing insolvent companies to remain solvent by borrowing more money, contributing to overcapacity and ultimately, disinflation. Coming full circle, the combination of monetary policy and regulation that was intended to rescue the market from deflation and make the financial system safe from collapse has ironically ended up creating … wait for it … deflation and instability. Here’s more from The Telegraph: 

Similarly, the violent and unprecedented “flash crash” in 10-year Treasury yields last October was blamed on faltering liquidity. The sudden drop in yields was all the more extraordinary given Treasuries are considered to be the most liquid market in the world.

 

But it is the corporate bond market where worries about trading conditions are most acute. The ultra-loose monetary policies pursued by the Fed, the Bank of England and the European Central Bank has resulted in a torrent of bond issuance in recent years from companies seeking to capitalise on rock bottom interest rates.

 

“Now is the perfect time to borrow if you’re a company,” says Gary Jenkins, a credit strategist at LNG Capital.

 

European and British companies, excluding banks, sold a combined $435.3bn (£291bn) of investment-grade debt last year, and $458.5bn in 2013, according to Dealogic. The level of issuance is much greater than before the financial crisis. In 2005, for example, $155.7bn was raised from corporate bond sales and $139.8bn the year before that.

 

Companies issuing riskier, high-yield debt have been similarly prolific. Last year, European businesses sold $131.6bn of so-called junk bonds, up from $104.4bn in 2013, the Dealogic data show. In 2005, they issued $20.4bn.

 

At the same time that issuance in the primary market has grown, trading of company bonds by investors in the secondary market has dried up, a liquidity shortage that ironically has been caused by regulators’ attempts to avert a repeat of the crisis that shook the financial system in 2008.

 

“Bank regulation is generally a good thing, but one of the unintended consequences has been the reduction in market liquidity,” says John Stopford, co-head of multi-asset investing at Investec Asset Management. “And that could come back to haunt us. People need to be aware of that risk and be prepared for it.”

This would be funny if it weren’t so tragically ridiculous because what it all boils down to is the fact that the world’s central banks have printed some $13 trillion over the course of five years and not only has it not had its intended effect, it’s actually made things immeasurably more precarious.

 

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Sun, 03/22/2015 - 18:26 | 5916345 Truther
Truther's picture

Got Gold Bitchezzzz?

Sun, 03/22/2015 - 18:48 | 5916419 indygo55
indygo55's picture

Distraction. The FED will never raise intrest rates.Unless forced.

Sun, 03/22/2015 - 19:02 | 5916452 Killer the Buzzard
Killer the Buzzard's picture

Bingo.  The Fed won't raise rates.  The market will.

Sun, 03/22/2015 - 20:59 | 5916713 weburke
weburke's picture

dont they raise rates when the 3 month treasury tells them too? and with no qe, emerging market money will flood here. 

Sun, 03/22/2015 - 22:17 | 5916940 odatruf
odatruf's picture

@Kill the Buzzard: by what mechanism will the market raise rates if opposed by the Fed? 

The Fed has bought as much as 80% of issuances at Treasury auctions, so why not 90% or even 100%? How can the market impose any discipline in that case? And if the Fed can twist or otherwise contort itself to buy corporate bonds via intermediaries, how again can the market impose anything?

Sure, the bond market size is enormous. But what evidence is there that anything will happen if the Fed printed whatever it took? And since these prices are set by the last marginal transaction, all the Fed needs to do is appear to be willing to buy anything without another bid or with a bid that is too costly.

I just don't know that any of us can say we've seen a limit to the Fed's capacity to blow up the balance sheet. I'd love to hear a counterargument to this. Thanks.

 

Sun, 03/22/2015 - 23:22 | 5917099 Squid-puppets a...
Squid-puppets a-go-go's picture

indeed. japan IS buying every bond. its also buying stawx openly. They have around 10-12% inflation i hear  (last year - has that dropped in the wake of global deflation?) - but not yet the hyperinflation we ZH types have been expecting

but with the integration of todays economy, maybe they're all just snowflakes on the same mountain side

Sun, 03/22/2015 - 20:09 | 5916601 BandGap
BandGap's picture

Forced or at a time of their choosing. Remember, Kyle Bass was told they want to destroy the dollar. What better scenario than raise rates when they want to.  We have been conditioned by the Fed, they pull the string when they are ready.

Sun, 03/22/2015 - 18:30 | 5916361 kaiserhoff
kaiserhoff's picture

Widening coporate credit spreads...

you mean there will once again be a difference between real companies and bull shit artists?

 

Sun, 03/22/2015 - 18:30 | 5916362 ah-ooog-ah
ah-ooog-ah's picture

I have plenty of liquidity right now. Nice bottle of Barolo in front of me. Not logging off till it's gone.

Sun, 03/22/2015 - 18:34 | 5916373 JBilyj
JBilyj's picture

so in the event of a market collapse in liquidity, would every sector, including pm miners be affected??

Sun, 03/22/2015 - 18:46 | 5916414 kaiserhoff
kaiserhoff's picture

Good question, but probably not.  As the article says, this is mostly a bond problem, and most bonds are illiquid in good times.  I think munies are in real trouble, but not something I trade.

Sun, 03/22/2015 - 18:48 | 5916418 Uber Vandal
Uber Vandal's picture

Refer to 2008.

Sun, 03/22/2015 - 18:56 | 5916434 kaiserhoff
kaiserhoff's picture

Stocks were liquid in 08,

 they were just falling like a rock;)

Good point.  The difference only matters if you have a long enough time line.

Sun, 03/22/2015 - 19:26 | 5916496 Vincent Vega
Vincent Vega's picture

Refer to Drexel Burnham Lambert.

Sun, 03/22/2015 - 18:50 | 5916423 Let The Wurlitz...
Let The Wurlitzer Play's picture

Looks for pm miners to have their assets taken by their host countries.  Most pm miners are in dodgy countries to start with.

 

Sun, 03/22/2015 - 18:45 | 5916408 buzzsaw99
buzzsaw99's picture

People need to be aware of that risk and be prepared for it.

BULLSHIT. there is no risk, there is only old yeller.

Sun, 03/22/2015 - 18:51 | 5916428 kaiserhoff
kaiserhoff's picture

And Ole Yeller blinked.  You were right again, Buzz,

But there is also Greece, Portugal, Spain, Italy..., but who really knows?

Sun, 03/22/2015 - 19:40 | 5916526 buzzsaw99
buzzsaw99's picture

we know for a fact that old yeller will defend 2000 on the s&p. all this talk about a rate hike is bullshit.

Sun, 03/22/2015 - 19:46 | 5916538 kaiserhoff
kaiserhoff's picture

I think she is defending the most corrupt banks,

but the result is much the same.

Mon, 03/23/2015 - 04:45 | 5917359 Wait What
Wait What's picture

Yellen is defending the S&P cuz she knows asset inflation is the only kind of inflation she can guarantee. if the Fed loses that battle, they lose their 'war' with deflation.

...little do the Fed ephors know, they've already lost a major  battle with the collapse of oil prices. it's just a matter of time before they rip the liquidity spigot wide open again. the longer oil stays lower, the more quickly you can expect it to happen.

as the saying goes, for a Fed with a liquidity hammer, everything looks like a nail.

Mon, 03/23/2015 - 06:27 | 5917411 new game
new game's picture

dr yeller has the unlimited ability to create liquidity, 4 trillion and counting.

so we have a liquidity problem? fucking lol'g. anybody here recall the fed balance sheet and line extended to ge alone? ge's lending units would have taken ge down to the mat, but wtf happened? buffet made a killing. hello, these cronies are licking their chops...another round of sweetheart crony deals served up in the shadows. get your billions, ha...

Sun, 03/22/2015 - 18:46 | 5916415 stingboo
stingboo's picture

We would have been climbing up & out of the shit by now... instead these pussies took the easy way out...with our money of course

Sun, 03/22/2015 - 18:47 | 5916417 Let The Wurlitz...
Let The Wurlitzer Play's picture

The lesson here is that you will never solve a debt problem with more debt.

 

Sun, 03/22/2015 - 19:20 | 5916483 kchrisc
kchrisc's picture

You will never fix a printed theft problem with more printed theft.
Unless also stealing your victim's collateral via default is your aim.

The banksters need to repay us.

 

I carry around a bag of marshmallows just in case I run into a bankster on fire.

Sun, 03/22/2015 - 22:16 | 5916935 SilverSavant
SilverSavant's picture

What a great idea!   I am sure that will spark a conversation.   Probably get real quiet after I tell them I am carrying them just in case I run into a banker that is on fire.   Here, I am starting the Marshmallows For Burning Banksters Club of the World right now.  Members are easy to recognize by the large bag of marshmallows hanging from their belt.    We can then adopt the Marshmallows for Burning Congresscritters into our Club and start a chain reaction that explodes into roasting opportunities in every corner of the globe without corners.   It is all coming together, a Vison is growing in my brain of how this is just the right level of intelligence and logic that the world can integrate into their worldview.  Who starts the Wars? Who steals your money while they ruin the currency?   Who is the main reason there isn't more peace and love in the world?   We have let them have their way for too long, it is time for the Marshmallows.

Mon, 03/23/2015 - 04:53 | 5917365 Wait What
Wait What's picture

more specifically, you can't fix a solvency problem with liquidity. the big fix is going to be a debtless society, but so many institutions now depend on debt up and down the heirarchy that its realization will truly be apocalyptic.

Sun, 03/22/2015 - 18:51 | 5916426 brushhog
brushhog's picture

Yet another reason why interest rates will not be raised in any significant way.

Sun, 03/22/2015 - 18:53 | 5916431 Bossman1967
Bossman1967's picture

Physical metals and no debt will survive this carnage whenever they decide to let this game end. It will be a decision and it feels like a trap better have food water tp and tampons for the ladies a shit storm is on the horizon

Sun, 03/22/2015 - 19:27 | 5916497 Charming Anarchist
Charming Anarchist's picture

Condoms before tampons. 

Sun, 03/22/2015 - 19:04 | 5916455 observer007
observer007's picture

 

#Bondmarket

 

Credit Default Swaps - Banks:

http://cds-info.com/

Sun, 03/22/2015 - 19:16 | 5916476 Unix
Unix's picture

LOL, that is RICH, I tell you! The spark has already happened, recall 2008-09, soon to be revisited with a vengeance, and even more pain to all around, except for the controllers...

.gov, .01%, pols, and bankers!

What's left for us little people, oh wait, crumbs!!

BASTARDS!!!!

Mon, 03/23/2015 - 01:12 | 5917261 old naughty
old naughty's picture

optimistic aren't you?

when the shitstorm hits, they will be DUMBed down; while their archon masters leave in their spaceships.

No crumbs.

Sun, 03/22/2015 - 19:28 | 5916501 madbraz
madbraz's picture

Treasury "flash crash" in october 2014?  You mean it "crashed" up in price like some 10% in the long bond?

Zero, a "crash" implies a large loss, not a massive gain.  The Fed, in all its corrupted ness, ordered primary dealers to halt trading - in essence doing treason against this country in an effort to avoid lower rates that would have killed derivative positions is some TBTF.

All in all, an idiotic post.

 

Sun, 03/22/2015 - 23:24 | 5917103 Squid-puppets a...
Squid-puppets a-go-go's picture

bond rates rising quickly is a crash in faith

Mon, 03/23/2015 - 01:57 | 5917292 Againstthelie
Againstthelie's picture

I had to read the article three times and I think I finally understand it. Not an idiotic post, quite the contrary.

The Oct'14 "flash crash" was a crash in YIELDS, not in treasuries value.

My understanding of the article is the following:

Usually an extremely liquid market, treasuries can be bought and sold and the price doesn't move.

Now the Central Banks bought this market empty plus regulations, so the liquidity, the readily available bonds have fallen. A sudden change in supply or demand now can cause big price movements.

Additionally the extremely low interest rates have created a wave of new junk debt, because now even almost bancrupt comapnies can issue debt at low rates.

And as the telegraph article mentions, traders are beginning to notice bad liquidity. That means they already experience problems to sell without damaging the price.

Now the very good article raises teh question: if this already happens BEFORE a rate hike and BEFORE rates start to rise, what will happen once the rate hike takes place and rates start to rise?

Food for thought. Excellent article.

Sun, 03/22/2015 - 19:53 | 5916557 Ban KKiller
Ban KKiller's picture

Blah, blah, fraud, blah, blah, fraud, blah, blah. FRUAD has a shelf life.   Some asshole always has to explain the truth to us serfs. What is on TEEVEE? 

Sun, 03/22/2015 - 20:31 | 5916647 lanchende
lanchende's picture

We liquified some folks....

Sun, 03/22/2015 - 20:38 | 5916668 disabledvet
disabledvet's picture

Only reason for the dollar sell off of this magnitude is because the Fed is going to QE 4.

 

Looks like oil is set for another dramatic fall as well.

 

Think I'm starting to see why currency traders are really into currency trading.

Sun, 03/22/2015 - 20:38 | 5916669 disabledvet
disabledvet's picture

Only reason for the dollar sell off of this magnitude is because the Fed is going to QE 4.

 

Looks like oil is set for another dramatic fall as well.

 

Think I'm starting to see why currency traders are really into currency trading.

Sun, 03/22/2015 - 21:08 | 5916754 holdbuysell
holdbuysell's picture

Unintended consequences indeed.

Mon, 03/23/2015 - 16:01 | 5916799 polo007
polo007's picture

Central bank balance sheets as percent of IMF nominal GDP:

http://fingfx.thomsonreuters.com/2011/12/21/1652597407.htm

Debt to GDP ratios:

http://fingfx.thomsonreuters.com/2015/03/19/111450d1ad.htm

Sun, 03/22/2015 - 23:42 | 5917130 Salah
Salah's picture

Politico-military "events", i.e. Russia invades Georgia, August 2008, triggers pending Lehman mega-event.  Putin got a quick tutorial on that one.

Stars were very much aligned then.  April-May looks good for a possible redux.


Mon, 03/23/2015 - 01:28 | 5917275 enloe creek
enloe creek's picture

Yemen dudes Yemen has a host of mountain shites fuckin doing it to the sunni shit faces.  Saudi scum bags can't help or isil may go in for the fuc fuc 

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