Over the weekend, we discussed the latest analysis by JPMorgan's Nick Panigirtzoglou according to which in addition to the literal lock up in equity markets (where S&P futures were halted limit down for hours overnight), credit and funding markets were starting to show signs of extreme stress, not only as a result of the sudden plunge in energy credits but due to a violent return of what appears to be systemic issues within the interbank funding market.
As the JPM quant summarized, "we see initial signs of emerging credit and funding stress. If these shifts in credit and funding markets are sustained over the coming weeks and months, especially in the issuance space, credit channels might start amplifying the economic fallout from the COVID-19 crisis."
To prove his point that the credit bubble was cracking, Panigirtzoglou highlighted the recent spike in the dollar fx basis, the latest burst of repo activity by the Fed, the spike in the SOFR rate and the SOFR-IOER spread, and last but perhaps most notably, the sudden blow out in the notorious FRA/OIS spread.
Fast forward 24 hours, when the cross-asset risk off cascade has been unleashed to levels not seen since the crisis , and the indicators of credit stress, had spread to the equity (and CDS) markets, resulting in a sudden collapse in liquidity, which as we pointed out last weekend was already record low (see "Two More Problems For The Bulls: Market Liquidity And Short Interest Are At All Time Lows")...
... and which has made navigating the market rout even more difficult, as there are large interval of time when even if securities are not locked limit down (or limit up in the case of the 10Y future), there is simply no market depth, i.e. liquidity.
Picking up on this, Bloomberg today writes that investors say it is becoming "increasingly difficult to trade due to the extent of swings on a day that saw 30-year Treasury yields drop the most since the 1980s and a fall in U.S. stocks so sharp that trading was halted minutes from the open" which has resulted in the biggest drop in financial conditions, i.e., market confidence and "lubrication" since since the 2008 crisis."
"I have yet to find liquidity," Nomura money manager Richard Hodges - whose bets on Italian and Portuguese bonds last year put him in the top 1% of money managers - told Bloomberg. "There is none."
To be sure, the plunge in liquidity is not just in equities, but has been observed across rates, credit and even VIX: earlier today a CBOE staffer said the VIX initially couldn't open due to an "absence of liquidity from market makers"
CBOE SENIOR TRADING DESK SPECIALIST: WE WERE INITIALLY UNABLE TO OPEN VIX OPTIONS TRADING THIS MORNING DUE TO ABSENCE OF LIQUIDITY FROM MARKET MAKERS
The evaporation of liquidity lead to huge swings in prices across all markets, resulting in a temporary halt of the entire CDS market as noted earlier, while in Italy one of the deepest pools of bond trading in Europe, two-year yields surged more than 50 bps at the European open, with unreliable bid and offer prices shown on screens. Indonesian and Mexican bonds also suffered a liquidity crunch, according to Allianz Global Investors.
But the most worrisome sign indicating the surging stress in money markets, is the same one JPM warned about on Sunday.
On Monday, one day after our credit lock up warning, Bloomberg picked up on the signals we highlighted and warned that "the key gauge of banking-sector risk" known as the FRA/OIS spread (one which we have discussed extensively in the past), soared to its highest level since 2011...
... while dollar swap spreads - which we also touched upon over the weekend...
... widened, suggesting stresses in U.S. markets are becoming increasingly severe.
Looking at the FRA/OIS spread in particular, we remind readers that there are typically 3 reasons why it would blow out:
- the risk premium for uncertainty of US monetary policy,
- recently elevated credit spreads (CDS) of banks and
- demand for funds in preparation for market stress,
Whatever the reasons, a blow outin FRA/OIS means that dollar funding is becoming increasingly problematic, and absent a sharp tightening in the Libor-OIS and FRA-OIS spread, while bank credit concerns may not have been the catalyst for the sharp spike, it will be banks that are eventually impacted by what is increasingly emerging as an acute tightening in short-term funding markets and/or a global dollar shortage.
Realizing it had to step in or else risk a Lehman-like market paralysis, the Federal Reserve on Monday increased the amount of temporary cash it’s willing to provide markets via repo.
- Beginning with today’s operation and through March 12, 2020, the Desk will increase the amount offered in daily overnight repo operations from at least $100 billion to at least $150 billion.
- In addition, the Desk will increase the amount offered in the two-week term repo operations on Tuesday, March 10, 2020 and Thursday, March 12, 2020 from at least $20 billion to at least $45 billion.
The modest boost however will not be nearly enough, and as Morgan Stanley said on Sunday night, the only thing that can push the market out of its funk is even more QE (which of course, is also a temporary solution, as it is doing more of the same that no longer works).
"The one thing I would say to buy is Treasuries," Priya Misra, global head of rates strategy at Toronto-Dominion Bank, said on Bloomberg Television, pointing to the risk of other markets drying up and perhaps ahead of what now appears to be almost inevitable QE. "If you own a ton of risk assets, the only safe haven asset right now is the 30-year. It’s shocking that I’m saying it."
Only even that's not true: there was a period of over an hour on Sunday night when the Ultra bond future was trading offerless, and not a single trade was possible in a market in which nobody wanted to sell what was deemed as the last safe asset.
Going back to the sudden evaporation of liquidity, Bloomberg notes that alongside the surge in FRA/OIS, a significant reason for the lack of depth in bond markets is the emergence in stress indicators of uncertainty about what the Fed will do next. One example is the fluctuations in liquidity in the financial system.
Liquidity strains - of the kind where people are once again looking at overnight funding markets - are unleashing "deep-seated fears that the coronavirus crisis could lead to the same dislocation of financial markets that we saw over a decade ago," wrote Steven Barrow, head of FX strategy at Standard Bank. "The worst-case scenario for the market is that dollar liquidity shortages start to emerge, putting leveraged borrowers in jeopardy."
That's precisely the risk JPMorgan highlighted when discussing the cracks emerging in the bond market.
The end result is a near record surge in volatility. The Bank of America Merrill Lynch MOVE Index, which measures price swings in Treasuries, jumped to the highest level since 2009 Monday.
Commenting on the sudden liquidity air pockets, Bloomberg Chief Global Derivatives Strategist Tanvir Sandhu wrote that "liquidity holes and the unleashing of suppressed volatility has seen convexity options outperform given the acceleration in volatility gains as tail risks reprice. For example, VIX calls funded by SPX puts would work for those looking for long convexity exposure. Now, extracting vol premium should come into play while managing the further deterioration of risk."
Yet while traders are looking at indications the financial collapse of 2008 may repeat, there is one novel wrinkle: the unprecedented proliferation of ETFs and passive investing. For Nomura’s Hodges, the problem is exacerbated by the proliferation of exchange-traded funds, something we discussed in "Market Crash Reveals The "Liquidity Problem" Of Passive Investing". The problem with passive investing is that while it propells market dutifully higher, when stocks crash, ETFs reverse, and a painful selling liquidation commences, one which takes a long time to stop, or as Bloomberg puts it, "when the market goes into freefall, they are required to sell the underlying asset, prompting a frantic search for anyone who will buy it."
In the end, Aberdeen Investment money manager Luke Hickmore put it best: "People are asking for bids and then dealing when they see them. You can definitely sell for sure, you just might not like the price."
He's right, for now. A few more days of liquidation panic, and there won't be a price at all: the market will simply be halted indefinitely, and nobody will know when (and if) they reopen, something we first discussed almost 6 years ago in "How The Market Is Like CYNK (Which Was Just Halted)"