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 [17]” 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 [18] 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 [19]” 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:
[20]
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 [21],
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 [22]. 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.
