Diary of a Financier

Grey swan files: “Bond market illiquidity”

In Capital Markets on Fri 12 Jun 2015 at 12:38

The whole discussion around (il)liquidity in the bond market is something I find fascinating. Consider the juxtaposition of narratives:

“The taper/end of QE will bring a rush of supply onto the market.”
“There’s no supply on the market.”

“We have to regulate banks/SIFIs to avoid a crisis.”
“Regulation will force a crisis since trading desks don’t inventory bonds anymore.”

…Etc., etc.

What follows is anecdotal, but the data supports a more objective narrative…

Over the last 3 months, every fixed income PM or strategist I’ve talked to has cited “liquidity” concerns for the bond market. Trading desks are complaining about it, mainstream media is talking about it, and the retail investor knows about it. I’m filing this under “known-unknown,” meaning it’s a threat that’s so widely acknowledged as to have already been slowly discounted by the market.

I liken this to the great junk bond crisis that we never had at the end of 2013, when everyone thought they were a contrarian calling for a crash, but in reality, they were all part of a homogenous consensus. That’s the taxonomy of a “grey swan“:

“Cassandras often shed light on looming catastrophe, allowing powers-that-be to preempt crises with fixes–let’s call it a self-fulfilling-fix. Therein lay the difference between a black and grey swan.”

…which is exactly what happened with credit in 2014q2/q3, when spreads gradually widened in a garden-variety correction after regulators quietly preempted a crisis by clamping-down on excesses.

While I clearly don’t expect today’s “liquidity risk” to result in a crash or crisis, I do expect it to be manifest as grey swans often are: yields will start discounting a liquidity risk premium for the first time in a long time.

Other than blips like 1997 and 2008/9, the promotion of deeper capital markets combine with the Great Moderation have whittled liquidity premia down to nil. Interest rates dynamically value inflation, growth, term, and credit components, but a liquidity variable has had little presence amidst this backdrop in the age of derivatives and ETFs. I’m certain that a liquidity premium re-valuation has already been responsible for part of the 10y yield’s 70bp rally from 1.65% to 2.35%, which also featured a 4% drawdown in the $AGG.

The liquidity concern is a many-headed beast. One argument is that a lot of marginal buyers are fast money, and some catalyst might force them to sell, triggering a cascading, systemic ripple-effect. But, come-on: retail investors’ fixed income allocations are back to historical norms after years of record fund flows. Fund managers have walked-back their bond underweights from extreme levels. Just this week, one of the biggest credit hedge funds closed its $20B AUM fund, returning capital to investors. All this means is that the loose hands aren’t holding massive bond allocations that they’ll flood into an illiquid market at the first sign of weakness. The investors holding whatever supply that’s out there are more strategic: banks, insurance companies & their ilk, who own bonds as regular course of business – more commercial than speculative.

Carry on, nothing to see here.




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