A day after we highlighted the veritable collapse in U.S. shadow banking liquidity (down by nearly half since 2008) occasioned by a potent one-two punch from Fed bond purchases and regulatory measures designed to stem prop trading (but which have apparently impaired market making), we get rumblings out of Japan that the BOJ might have hit the limit on how many JGBs it can purchase without breaking the market. Specifically, Yuri Okina, vice chairman at Japan Research Institute, is concerned about the exact same issue raised by the Center for Financial Stability in their report on the “steep slide” in market finance: namely, that the absence of liquidity created by QE will create distortions and volatility.
“If additional easing is done using government bonds, it may have the considerable side-effect of impairing the functioning of the market,” Okina, an economist and a former BOJ official, said on Feb. 26 in an interview in Tokyo.
The BOJ’s purchases have had a “huge” impact on the market’s liquidity, Okina said. Buying bonds at a faster pace would make it more difficult for the BOJ to exit from its easing policy when the time comes to reduce stimulus, she said.
Clearly there’s something self-evident (even tautological) about this discussion. That is, the BOJ is set to monetize all JGB gross issuance in 2015 (and may own 50% of the entire market within three short years), so yes, there are likely to be rather serious issues with market liquidity going forward.
What’s especially perturbing about this scenario, is that sapping liquidity from the market has the potential to create enormous volatility (as we saw on October 15 of last year when Treasurys staged a six standard deviation move in the space of a few hours), something the pot committed BOJ simply cannot afford lest the house of cards should come cascading down. In other words, if yields on JGBs become increasingly unwieldy because either traders lose confidence in the central bank’s ability to manage the ponzi or a lack of liquidity triggers excessive volatility (or both), it’s game over or, as BlackRock put it: “...the nightmare scenario would be a spike in JGB rates leading to a fiscal crisis.”
Given this, it doesn’t inspire much confidence that the BOJ’s actions are curtailing price discovery. Here’s Bloomberg again:
Primary dealers responsible for distributing JGBs to investors told the government in November it was getting harder to determine prices because net supply was low.
...and with no price discovery comes volatility:
Yields on benchmark 10-year Japanese government bonds fell to a record low of 0.195 percent on Jan. 20 before swinging to a two-month high of 0.45 percent on Feb. 17. Historical volatility for the past 30 days touched a 21-month high of 4.56 percent on Feb. 25.
Just as the SNB finally buckled in January, and just as the ECB faces the prospect of failing to deliver on its trillion euro Q€ promise, the BOJ could be nearing the dreaded inflection point where the market realizes once and for all that the emperor truly has no clothes. A few more auctions like last month’s 10- and 5-year sales could well accelerate the process -- this month's 10-year auction is tomorrow.
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In related news, the SEC's Daniel Gallagher said today that regulators aren't doing enough to mitigate the risks posed by an increasingly illiquid corporate bond market. As we noted yesterday, the unwillingness of primary dealers to hold inventories has, to use the CFS's terminology, created a situation where "an accident" is likely.
More from 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”
“I would submit to you that the lack of liquidity in our securities markets is a systemic risk,” he says at conference sponsored by Institute of International Finance.
...and a bit more from BofAML for good measure:
Historically, dealers provided liquidity by buying bonds when investors wanted to sell, selling bonds when investors wanted to buy and by holding sufficient inventory level.
Onerous capital charges imposed on many securitized products has resulted in shrinking dealer balance sheets, less competitive bids for bonds unless buyer is already lined up.
“While this has reduced trading flows and muted spread volatility over the last year or so, it potentially sets the stage for a significant volatility spike if an event, such as the downgrade of the U.S. long term debt in 2011, was to occur and the markets broadly entered risk-off mode.”
To extent dealers unwilling/unable to step in and provide liquidity, spreads will need to widen until they hit clearing levels attractive enough for other investors to step in.