It was about a year ago when [12], 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 [13], 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 [14]and 2013 [15], 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 [16]:
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.
[17]
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.
