Over the course of the last year or so, bond market liqudity has become the talk of the financial universe.
We, of course, have been pounding the table for years [12] when it comes to illiquid phantom markets, but it took a flash crash [13] in what everyone still assumed was the deepest most liquid market in the financial world (that of USTs) and a rather unsettling Bund VaR shock [14] six months later to wake regulators, pundits, PhD economists, and the entire Keynesian cabal up to the fact that liqudity has all but vanished from virtually every tradable market on the planet.
Who's to blame? Lots of folks, but we can simplify things by saying that when it comes to government bond markets, central bank asset purchases (which have served to suck every last bit of high quality collateral out of the market, leading to aberrations like every PSPP-eligible Bund trading special and the 10-year UST trading 220bps negative [15] in repo ) and stop-hunting, market manipulating algos are the primary suspects while an ill-conceived post-crisis regulatory regime and a spiteful sellside have conspired to ensure that when all of those yield-starved investors who snapped up record corporate issuance go to sell in the secondary market no one will be home to inventory the bonds.
So, the question becomes: what happens when the crowded theatre analogy plays out in illiquid credit markets?To let the IMF tell it, central banks will be forced to step in and play market maker.
Here’s Reuters [16]:
Central banks may need to become "market makers of last resort" if there is not enough liquidity during volatile sell-offs, a senior International Monetary Fund official said on Thursday.
Regulators worry that when interest rates begin rising from their prolonged low levels there will be a stampede for the exits by bond investors and that markets won't have the liquidity or capacity to deal with it smoothly.
The prospect that the Federal Reserve may start raising rates later this year has already prompted "taper tantrums" or severe volatility in global financial markets.
Jose Vinals, director of the IMF's capital markets department, said market liquidity has shrunk as capital requirements on banks have increased but that there was no simple relationship between the two.
Central banks buying bonds to conduct unprecedented stimulus programmes over the last three years -- most recently the European Central Bank -- have also been blamed for sucking volume out of the market, making it less liquid.
"The time it takes for the global regulatory community and central banking world to find a solution this time may be longer than the time where one episode of big illiquidity happens," Vinals told a meeting of the International Organization of Securities Commission (IOSCO) in London.
"Then the question is what to do. In my view the only thing that can be done at that time is that central banks should become again market makers of last resort."
In other words, DM central banks, which have already ballooned their balance sheets into the trillions by onboarding everything from negative-yielding periphery sovereign debt to Japanese ETFs to billions in Apple shares [17], will now need to step in and buy whatever everyone is trying to sell (HY for instance) in the event of a panic, in what will simply amount to yet another attempt to stave off creative destruction by printing fiat currency.
Ironically (given what's been going on at the Hang Seng over the last several months) it's Ashley Alder, chief executive officer of Hong Kong's Securities and Futures Commission, who has perhaps the best assessment of why the above is ludicrous:
"If you react to that by piling more intervention on intervention, you encourage more untoward risk taking and you end up with even greater amount of mispriced risk. You end up with a never-ending cycle that is harder and harder to get out of."
We couldn't have said it better ourselves.
