It has now become fashionable in the world of high finance to express extreme consternation about reduced liquidity in the bond market. Last week, Jamie Dimon spelled out the problem as follows:
The likely explanation for the lower depth in almost all bond markets is that inventories of market-makers’ positions are dramatically lower than in the past. For instance, the total inventory of Treasuries readily available to market-makers today is $1.7 trillion, down from $2.7 trillion at its peak in 2007. Meanwhile, the Treasury market is $12.5 trillion; it was $4.4 trillion in 2007. The trend in dealer positions of corporate bonds is similar. Dealer positions in corporate securities are down by about 75% from their 2007 peak, while the amount of corporate bonds outstanding has grown by 50% since then.
Meanwhile, complacency in credit markets is building as the central bank-driven rally has left few opportunities in its wake, prompting DoubleLine to note that US corporate credit currently offers the most unpalatable risk/return proposition in history and leading some bond traders to turn Monday into “the new Friday.” Couple all of this with the fact that one “malfunction” by a “liquidity providing” algo could, at any given time, trigger a repeat of October’s Treasury flash crash sending ripples through credit markets at a time when nobody is home on the sell side (both figuratively in the form of dealer inventories and literally on “new Friday Mondays”) and you’ve got yourself a perfect storm.
Given all of this it’s not surprising that yet another executive is out raising the liquidity red alert. Here’s Bloomberg:
Prudential Investment Management Chief Executive Officer David Hunt says the No. 1 concern among bond buyers globally is liquidity and its rapid disappearance.
“The biggest worry of the buy side around the world is that there has been a dramatic decline in liquidity from the sell side for many fixed income products,” said Hunt, 53, who heads Prudential Financial Inc.’s investment management unit, which had $934 billion in assets at the end of 2014. “I think it’s a big risk and is one of the unintended consequences” of regulators trying to prevent another financial crisis, he said.
Note the irony: the biggest risk to the global financial system stems from regulatory efforts to head off risks to the global financial system.
While the size of the U.S. bond market has swelled 23 percent since the end of 2007 through the end of last year, trading has fallen 28 percent in the period, Securities Industry & Financial Markets Association data show, as regulators, seeking to reduce risk, have made it less attractive for banks to hold an inventory of tradable bonds. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon warned in a report last week the next financial crisis could be exacerbated by a shortage of U.S. Treasuries.
“If we had a major political event or something that caused rates to spike and traders needed to get out of the current position they have, and there was a lot of people that wanted to do that, I think it would be quite difficult,” Hunt, in Tokyo last week for various management meetings, said. He declined to comment on what measures Prudential is taking to lower liquidity risk, saying that information was sensitive from a competitive perspective.
Once again, the writing is on the wall and as (another) reminder here is the problem: 1) demand for corporate credit is high thanks to the global hunt for yield occasioned by central bank easing, 2) corporates are thus issuing a lot of debt to tap into voracious demand before the Fed embarks on a rate hike cycle, 3) dealer books are shrinking thanks to regulations designed to limit prop trading, 4) and so the primary market is booming while no one is home in the secondary market. We’ll close with what we said on Monday in “Human Bond Traders Barely Show Up To Work As Machines Take Control”:
Meanwhile, the new regulatory regime has done an admirable job of making the system “safer” by encouraging dealers to shrink their inventories, meaning that while we’re all safe from evil prop traders (because we’re sure prop trading is dead and the Goldmans of the world didn’t find a way around Volcker the very instant it was proposed), secondary market liquidity has evaporated, meaning the door to the proverbial crowded theater is getting smaller even as the number of yield seekers inside is getting larger so when someone finally yells fire, well, let’s mix our metaphors here and say we’re all up a creek.