Last Saturday in “Behind The Scenes In FX Trading: What Is Really Going On”, we showed that as stop-hunting algos descend on the FX market, liquidity is drying up. More specifically, we looked at a Hui and Heubel ratio (basically a measure of how much trading is going behind observable price moves) that JP Morgan constructed to measure FX liquidity and we also examined FX market volatility and bid-asks on the way the drawing the following conclusion:
Rising volatility, wider bid-asks, and no liquidity. Sounds a lot like the JGB, UST, and Bund markets to us and indeed every other 'market', which is why you can expect things like last October's algo-driven, Fed-assisted Treasury flash crash to become par for the course in FX markets as well, with harrowing USD, EUR, JPY, [fill in the blank] ramps and flash crashes becoming the norm and leaving panicked central bankers desperately trying to figure out what happened after the fact.
This week we get still more evidence of illiquid markets courtesy of JPM. What follows is an up-to-date look at conditions in corporate credit and Treasurys.
For corporate credit it’s the same story. The post-crisis regulatory regime has made dealers more reluctant to hold inventories, making the secondary market especially thin at a time when the primary market is booming thanks to a ZIRP-inspired supply bonanza, setting up a rather precarious situation akin to the old 'crowded theatre' analogy.
What about market depth in corporate bonds, a universe whose deterioration in liquidity was the first to be talked about after the Lehman crisis? We construct similar metrics for US for corporate bonds using FINRA Trace data. In particular we divide the dollar value of trading by the number of trades for US IG, HY and Convertible corporate bonds. These metrics are shown in Figure 5 (turnover) and Figure 6 (average trade size). There appears to have been a structural damage since the subprime crisis of 2007 and the Lehman crisis of 2008 with both turnover and market depth (i.e. average trade size) deteriorating.
Similar to equities, we believe that dealer retrenchment, greater fragmentation in trading, and heightened regulatory costs are responsible for the structural damage in corporate bond trading liquidity.
Note the divergence between IG and HY on the turnover chart. JPM attributes this to “the proliferation of HY corporate bond ETFs” which the bank says “has helped secondary market liquidity for the underlying HY corporate bonds.” Perhaps, but as we discussed in “ETF Providers Quietly Prepare For Market Meltdown With Billions In Emergency Liquidity,” fund managers are growing increasingly concerned about what will happen should investors in relatively esoteric fixed income ETFs suddenly decide that they want out, forcing ETF issuers to sell all at once into an illiquid underlying market. In other words, when all the HY issuers who have been living on Fed-assisted borrowed time by taking advantage of investors’ thirst for any semblance of yield start to buckle under the weight of their re-leveraged balance sheets, the dumb money will suddenly discover all at once that yields do indeed move inversely to prices and once they start selling, we’ll see just how illiquid the underlying markets truly are.
Indeed, illiquidity in corporate credit markets has become somewhat of a topic du jour, with AP now running a lengthy piece on the dangers embeded in HY credit.
If high-yield bond prices start to tumble, there's a concern that the market will become illiquid -- meaning fund managers will have a tougher time finding buyers when they want to sell bonds. In the past, big banks would help with liquidity by buying when the market was too skittish, but new regulations are making banks less willing to step in when there's a sell-off in the market. Market watchers have been warning that liquidity is worryingly low.
Fund managers say they've already seen signs of lower liquidity. Prices for bonds move more quickly than they did in prior years, says Richard Lindquist, head of the high-yield fixed-income team at Morgan Stanley Investment Management. Last year, for example, when the high-yield market was struggling with the fallout from the plunge in oil, bond prices were quicker to fall. This year, as the high-yield market has recovered, prices have been quicker to rise. But he says he still can find buyers for bonds he wants to sell.
As a reminder, here is all you need to understand post-crisis dealer retrenchment and the relationship between declining dealer inventories and the proliferation of ETFs:
As for Treasurys it is again, a familiar refrain. A collateral shortage created by QE is still severely impacting market depth:
How does the picture in Figure 6 for the market depth of US corporate bonds compares to our market depth metric for USTs? The latter is proxied by the 5-day average of tightest three bids and asks each day, shown in Figure 7 in $mn for 10y US Treasuries. Similar to US IG corporate bonds, there was an earlier collapse in market depth during 2007 already as the US subprime crisis erupted. But different to US IG corporate bonds, there has been a deterioration in UST market depth in the most recent years, since 2013. We argued before that the deterioration in UST market depth since 2013 reflects the contraction of US repo markets caused by regulations as well as UST collateral shortage induced by the Federal Reserve’s QE3 program coupled with a declining US government deficit (see previous Flows & Liquidity, Reverse repos do little to alleviate UST collateral Shortage, July 11th 2014). A retrenchment in repo markets is unwelcome news for the liquidity of the underlying securities. Most repos, around 80%-90%, are against government-related collateral and it is the repo market which makes government securities relatively more liquid by allowing fast and efficient financing and short covering. It is not accidental that trading volumes in bond markets are so closely related to the outstanding amount of repos. See previous Flows & Liquidity “Leverage ratios to hit repo markets”, July 19th 2013 which shows that US outstanding repo amounts and overall bond trading volumes have been drifting lower in recent years with no signs of a return to pre Lehman levels. And similar to USTs, Bund and JGB market depth has been also suffering as a result of government collateral shortage inflicted by the ECB’s and BoJ’s QE programs and shrinkage in their respective repo markets.
The inescapable conclusion: the markets are broken. Plain and simple. Successive rounds of government bond monetization have worked to destroy the Treasury, JGB, and EU core markets while the post-crisis regulatory regime has seen dealers back away from providing liquity in the secondary market for corporate credit just as the very same monetary policy that broke government bond markets has led to an explosion of new issuance from corporate borrowers creating the potential for a self-feeding catastrophe in the event of selloff in corporate bonds. Here's JPM summing up:
To conclude, all markets, equity, corporate and government bond markets had seen a collapse in market depth as a result of either the 2007 US subprime or the 2008 Lehman crisis. For all of them, market depth remains well below pre crisis levels.