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It's a trap!!

dazzak's picture




 

Be kind, unwind

Since the beginning of the month we have had failed BOBL auction and Mr Bill Gross’ piece about how the bond markets are offering the sale of the century Bund yields have exploded 41 B.P. while US 10yr yields by 28 B.P., accompanied with a large spike in implied volatility across the curve. Although some of this has been viewed as just a position unwind the speed and herding mentality of the markets has given me a major cause of concern……

10 year yield

There are reasons to believe that the worst phase of the sell off may be ending as inflation expectations are adjusted as the curve bear steepened may make sense ,be it with the rally in the crude market or adjustments due to the fact that the curve flattening bought on by QE had gone too far....but it is the voracity of the pain trade unwind which ,in turn has caused a massive increase in volatility that has shown that it has the potential to upset the apple cart.

ITS A TRAP!

Water, water, everywhere

On many metrics, liquidity across markets seems abundant. Bid-offers are tight, if not always back to pre-crisis levels. Exchange traded volumes have reached all-time highs. The rise of electronic trading is helping to match buyers and sellers of securities more efficiently than ever before.

But not a drop to drink

And yet almost everyone, in almost every market, seems worried about liquidity. Even if it’s here today, they fear it will be gone tomorrow. HFT and electronic trading contributes to most of the increased volume however the growing frequency of “flash crashes” and “market gaps” – often without obvious cause – adds weight to their fears.

Run away, run away….

One explanation is that increased regulation has driven up the cost of balance sheet and reduced the bank’s appetite for risk, and hence ability to act as a middleman between buyers and sellers.This leaves the propieatry trading firms as the only sourse of liquidation by the funds.

 

But in addition to regulations, central banks’ distortion of markets has reduced the mix of views in the market, forcing investors to be the “same way round” over the past four years to a greater extent than ever previously. This creates markets which trend strongly, but are then prone to sudden corrections. It also leaves investors more focused on central banks than ever before – and is liable to make it impossible for the central banks to make a smooth exit.

Liquidity is very much in evidence when not required, and then disappears without trace the moment you need it....There is an argument that the liquidity provided by electronic trading are less substantial than that stemming from voice trades, floor trades (where it still exists) and personal relationships. When markets become volatile, firms tend to pull the plug – or, at best, reduce the size they are willing to trade.

In addition to bank regulations, there is a broad-based problem insofar as the investor base across markets has developed a greater tendency to crowd into the same trades, to be the same way round at the same time. This “herding” effect leads to markets which trend strongly, often with low day-to-day volatility, but are prone to abrupt corrections. Electronic trading reinforces this tendency, by creating the illusion of liquidity which evaporates under stress.

 Unlike the trading floors, which had the advantage that there was always someone is there to make a price. In the current environment it is easy enough to “turn the machine off” and not answer the phones.

Up to now, the flash crashes have been little more than a curiosity, having mostly been resolved very quickly, and having had little or no obvious follow through to longer-term market dynamics, never mind to the real economy.

But ignoring them would be a mistake. Each has occurred against a largely benign economic backdrop, with little by way of a fundamental driver. And yet with each one, investors’ nervousness about the risk of illiquidity is likely to have been reinforced.

Missing in action

The finger is most often pointed at the street. Many feel that bank’s willingness to act as a liquidity provider even during good times has waned;
in Jamie Dimon’s recent letter to JPM shareholders. He cited three factors: Higher cost of balance sheet Explicit constraints for US banks as a result of the Volcker RuleThe fact that the rescues of the likes of Bear Stearns, WaMu and Countrywide have led not to gratitude but to heavy fines for JPMorgan and Bank of America.
Is it getting worse?
A recent IMF analysis concluded that it was precisely such a reduction in the depth of order books on the electronic exchanges that seems to have led to the ‘flash rally’ in US Treasuries on October 15th 2014. This also seems to have been the main contributing factor to the flash crash in equities on May 6th 2010 as opposed to an Evil Englishman sitting in his semi-detached house in London plotting the downfall of the US markets!!!!!                                                                                                                                                       
MOOOOOOOOOOO!!!!!                                                                                                                            
For the last few years, valuations in more and more markets seem to have stopped following fundamental relationships and instead followed global QE. How much time is spent discussing fundamentals these days, and how much revolves around central banks?
Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the ‘same way round’ to a much greater extent than previously.
Unfortunately, this end result of this is fairly ominous. The bouts of illiquidity will continue and will likely intensify: unless fundamentals move so as to justify current valuations.
The markets will continue to gap to a point where they will go from being ridiculously expensive to being absurdly cheap, without very much trading in-between. But the existence of the feedback loop to the real economy means that the fundamentals tend also to be affected by extreme market moves: “cheap” may be a moving target. This in turn could force central banks to step back in again.                                         
What we are left is......


“The more liquidity the central banks add, the more they disrupt the natural order of the market.”

 For the last few years it has mostly proved possible to accommodate this; however the way out may not prove so easy; indeed, I ‘am not sure there is any way out at all.

 

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Thu, 05/14/2015 - 00:33 | 6092005 Cityzerosix
Cityzerosix's picture

At length did cross an albatross.....

Wed, 05/13/2015 - 20:35 | 6091477 flyonmywall
flyonmywall's picture

Lots of people cashed out of the California market at the top, went to Illinois or Ohio. Then, slipped on the ice, fell down, broke a hip, ended up in the hospital, then on disability. They are now sucking down the disability paychecks, getting chauffered around in their Benz, and going on cruises to Singapore and Greece.

True story, from my father-in-law. These parasites are still around.

 

Wed, 05/13/2015 - 22:19 | 6091732 willwork4food
willwork4food's picture

A person that sold their home in Cali at the top then requested retirement disability is a parasite? What are you fly? In the 9th grade?

 

Wed, 05/13/2015 - 18:02 | 6091014 Par Contre
Par Contre's picture

The longer central banks hold rates at artificially low levels, the greater become the forces of economic nature pushing in the opposite direction. When this sucker goes, look out below.

Wed, 05/13/2015 - 17:30 | 6090946 Fahque Imuhnutjahb
Fahque Imuhnutjahb's picture

Everyone needs to chill!!  This ain't nothin but a thang.  If things begin to spin out of control TPTB can always commandeer bank deposits, money market funds, 401K holdings, etc.. in order to stabilize conditions.  Geez, get a grip; all the gloom and doom!  It's like you guys think a crisis would be intentionally perpetuated just so a few chosen could capitalize, wake up and take the tinfoil hat off after you pull your heads out of your asses.

Wed, 05/13/2015 - 17:24 | 6090930 SmittyinLA
SmittyinLA's picture

thought was going to read about CA 

Wed, 05/13/2015 - 17:17 | 6090890 Bemused Observer
Bemused Observer's picture

Why doesn't California just order a whole bunch of this stuff...
http://dripdrop.com/

Wed, 05/13/2015 - 17:20 | 6090908 Bemused Observer
Bemused Observer's picture

Sorry! Wrong post...I meant this for somewhere else...

Wed, 05/13/2015 - 12:24 | 6089662 Downtoolong
Downtoolong's picture

"floor trades (where it still exists)"

I’m already convinced that Rick Santelli’s regular rants on CNBC are all filmed from a sound stage in Newark made up to look like the floor of  the CBOT. All those floor traders and brokers running around are actually actors hoping for a big big break as an extra in the next catastrophe film – “Marketageddon”.

Wed, 05/13/2015 - 11:54 | 6089579 GRDguy
GRDguy's picture

Liquidity trap simply means running out of greater fools to buy your stuff.

Wed, 05/13/2015 - 11:34 | 6089503 Downtoolong
Downtoolong's picture

There is only true form of liquidity in any market. That’s when you have participants in the market who are there for different reasons and who have natural incentives to take each other’s side of a trade.

An analogy would be the relationship between a heating oil company and one of it’s customers. In a severe winter, the heating oil company profits more while their customer’s costs go up.  In a mild winter, the outcome is reversed. Each has a natural incentive to be on the opposite side of a hedge trade in heating oil futures to help mitigate their risk.

The author is right; liquidity ceases to exist as soon as everyone is the “same way round” in a market. When everyone naturally wants to be on the same side of a trade, it’s the antithesis of liquidity. The price shocks we see are just symptoms of that underlying illiquid condition, and no amount of Central Bank money printing or HFT churning volume can replace it. It isn’t that liquidity suddenly disappeared just before the shock. It’s that uber cash reserves and HFT volume provides the illusion of liquidity that was never there to begin with.    

Wed, 05/13/2015 - 11:25 | 6089473 Gohigher
Gohigher's picture

“The more liquidity the central banks add, the more they disrupt the natural order of the market.”

The increasing "Mark to Matrix" is giving me the blues ......

"We bubbled some folks..... now into the railcars, a free re-education awaits each of you"

Wed, 05/13/2015 - 11:51 | 6089566 Urban Roman
Urban Roman's picture

... right after the flea, louse, and bedbug treatment.

Wed, 05/13/2015 - 10:44 | 6089341 the grateful un...
the grateful unemployed's picture

there is no liquidity problem, liquidity is push button. flash crashes are no problem, you close the market, cancel the trades and restore the bid ask to where it was in the first place. the problem is the scale of the market and the players in that market. if you hold a security that trades 1000 units a day, and you have 100000 units you want to sell, you either must dump that quantity off in small bites, or arrange a block trade. block trades are done between institutions, and with QE between institutions and the government. it essentially allows a holder of a security to sell it across the lighter volume of the regular market, without affecting the price. there is often a quid pro quo involved, and nowadays plenty of derivatives (and what happens when the guy holding the derivatives can't balance his books - AIG) without the quid pro quo or the derivative offset the block trade would be legit, its when other things get added. QE was just a government backstop, and so there is no problem, if you have a ton of bad securities you hand them to JY. except of course that program is temporarily ended. and the ability of the government to take all the bad securities via this block trade is limited, just like FDIC, which is why Goldman has FDIC.

these are all off balance sheet solutions. we ran the Iraq war off balance sheet, if you abolished the fed tomorrow the Treasury would put that paper off balance sheet. going off balance sheet has a real negative connotation, but the stock market went straight up after shock and awe. its like a gambler using his line of credit, then asking for another. the second problem is when the value of one balance sheet isn't the same as the other. normally you try to cheapen debt accumulated when money was dear. inflate away your debts. however past a certain point raising interest rates contributers to deflation, not the other way around. you can't go back and fix it.

 

Wed, 05/13/2015 - 10:49 | 6089340 the grateful un...
the grateful unemployed's picture

at issue is the price discovery mechanism, which is figured on a lighter volume than the block trades. if joe and bob are the only two guys in the gold market and joe says name your price, you go higher, or otherwise.

Wed, 05/13/2015 - 11:52 | 6089306 Urban Roman
Urban Roman's picture

Just shut up and BTFATH, putaz!

Wed, 05/13/2015 - 10:09 | 6089185 BoPeople
BoPeople's picture

It seems that anything that becomes illiquid they rush to turn into a derivative that they can use as collateral to create more liquidity. So now, there are seemingly all these sour derivatives that can never be market to market.

Wed, 05/13/2015 - 13:07 | 6089469 KnuckleDragger-X
KnuckleDragger-X's picture

A small bond run is how I figure the crash will start. The 'smart' people like to talk about the safety of bonds but even a small bond run will wipe out liquidity, which will, of course, start a bigger panic and things will go strange. All the CB's in the world can't create and distribute money fast enough to stop a collapse and derivatives will guarantee a giant bonfire.... Almost time to buckle up for the ride....

Wed, 05/13/2015 - 13:15 | 6089844 madbraz
madbraz's picture

iliquidity in treasury market would be a problem if there was a shortage of demand.  what we have here is a shortage of supply and institutional holders of treasuries are not speculators who will sell based on some short term shenanigans being performed by speculators in the futures markets.

Wed, 05/13/2015 - 13:53 | 6089924 KnuckleDragger-X
KnuckleDragger-X's picture

Treasury bonds are a small part of a very big market, and right now a lot of people are doing the safety dance. Unfortunately, overall treasuries really aren't any better in a bond collapse.....

Wed, 05/13/2015 - 10:54 | 6089379 the grateful un...
the grateful unemployed's picture

i dont how they could ever orphan a bond, once they let the home equity ATM genie out of the bottle, you can monetize anything. i thought the home equty line was a pretty clever way to get money that was locked up out into the economy and circulating. there is still some debate about what the effect of that was, irrational consumption, or paying down outrageous health care costs, or reinvestment into the home, which caused the housing bubble. the home has always been considered a savings bank, a retirement fund. that myth has ended i think. a house is just another consumable, around which a number of cottage industries have grown, a consumable which has added costs to operate. the real craziness is using this new power to monetize through derivatives and then expecting those derivates will never be market to market, or monetized themselves.

Wed, 05/13/2015 - 11:46 | 6089550 Comte d'herblay
Comte d'herblay's picture

Except for the values of houses in the San Francisco area, Silicon Valet, and other selected environs whose markets defy the notion of a house now being a consumable.

I wonder how many bought a home in the 70s, 80s or 90s, for 10% - 20% of what it has been worth over the ensuing 2 decades, then cashed out and headed for cheaper digs in Ohio, West By god, or other more sensible markets, financially secure with their million (s) dollars in the bank for selling out, retired at 40 or 50. 

 

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