Yves here. The financial press has traders blaming regulations for recent bond market volatility. While banks have decided to reduce trading inventories, it’s not hard to imagine that the much bigger perp is the Fed’s regular threats to end ZIRP as soon as they possibly can. Complaints about liquidity translate as “I can’t sell as a price I like.” Well, who is going to want to go any longer in bonds right now with the Fed itching to hand you losses?
By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street.
Axel Weber, president of the Bundesbank and member of the ECB’s Governing Council until he quit both in 2011 to protest the ECB’s bond purchases, quickly landed a new gig: chairman of UBS. WHIRR went the revolving door. From this perch, he warned in 2012 that the easy-money policies and the expansion of central-bank balance sheets would lead to “new turmoil in the financial markets.” Now that the turmoil has arrived, he’s at it again.
“Volatility and repricing” – a euphemism for losses – are “part of getting back to normal,” he told NBC. We should get used to it, he said, echoing what ECB President Mario Draghi had said a couple of days ago. So no big deal. However, he was fretting “about the liquidity in the market, in particular under stress situations.”
Despite unleashing a deafening round of QE on the European markets, the ECB has watched helplessly as government bonds have done the opposite of what they should have done: Prices have plunged, and yields have spiked. The German 10-year yield soared in seven weeks from 0.05% to over 1% on Thursday, before settling down a bit. And it wasn’t even a “stress situation.”
US Treasuries have sold off sharply as well since the beginning of February, with the 10-year yield jumping from 1.65% to 2.31%, the worst selloff since the taper tantrum in 2013.
Now one word is on the official panic list: “liquidity.” They’re thinking about the terrifying moment when it suddenly evaporates.
Weber blamed central banks for the liquidity issues in the global bond markets. They’ve been buying “vast amounts of assets and putting them on their balance sheets”; not just government bonds but also corporate bonds. Since central banks “buy and hold,” they “take some liquidity out of the market.”
He pointed at regulation that “has moved a lot of banks out of market-making into more long-term sustainable business models,” he said. UBS, for example, has turned from investment banking to wealth management.
And the Fed’s forward guidance has changed from a nearly unified statement about not raising rates to a cacophony on whether to raise rates earlier or later. “That actually impacts pricing in the market; market moves are then translated into much bigger moves because people aren’t on the same page.”
Everyone is chiming in with their fears that liquidity in the bond market will dry up just when you need it the most.
The liquidity that investors believed they had in the bond markets was “illusory” during the last crisis, explained Fed Governor Daniel Tarullo at an Institute for International Finance summit on Thursday. Like Draghi, Weber, and many others, he said that investors should get used to more volatility. It’s liquidity they’re worried about.
So in effect, get used to selloffs. It’s all part of “re-pricing,” as Weber had put it so eloquently. It’s the new normal. IF there is enough liquidity, “re-pricing” is going to be orderly. But that’s a big IF.
The next crisis will “probably be oriented to lack of liquidity,” BlackRock CEO Larry Fink said at the same summit. And there’s “the potential for frozen markets….”
That’s when everyone panics.
But the bond rout might have another cause, one that has been assiduously denied all around: Inflation expectation (as measured by the difference in yield between 10-year Treasuries and 10-year Treasury Inflation Protected Securities) is 1.8%. On a 10-year investment, it’s logical that investors would want to beat inflation by a smidgen.
Some markets are by nature illiquid. The housing market, for example. When you put a home on the market in normal times, you might get an acceptable offer after a couple of months. If the market turns sour, you might not be able to sell it at all at a price you can live with. Or you might have to drop the price by 30%. That’s lack of liquidity.
At the rarefied air where properties sell for tens of millions of dollars, it can take years to unload a property. The California mansion used in Scarface came on the market in May 2014 at $34 million. Recently, the price was dropped to $17.8 million. Lack of liquidity. In the housing market, it’s expected.
Homes, classic cars, art, farmland, a factory… they’re all more or less illiquid assets. Everyone knows it, and so it’s no big deal. Until there’s a bust, and then suddenly it’s a big deal.
Bond markets are supposed to be fairly liquid, with the US Treasury market being the most liquid. Corporate bonds are less liquid. Each bond issue is different, and even in good times, it may take days to find a buyer for a particular bond at a price that won’t kill the seller. But when liquidity dries up – that is, when buyers with liquidity lose interest – these bond markets can seize, and that’s when forced selling leads to a collapse in prices, runs on bond funds, panic, and mayhem.
Even conservative sounding “open end” bond funds can get eviscerated when they experience a run and are forced to sell their holdings into an illiquid market [Are These Ticking Time Bombs in Your Portfolio?].
Stock markets are very liquid, supposedly. Trading is electronic, accomplished in microseconds, with prices disseminated globally in real time. Manipulation runs rampant, and you get screwed, but you can always assume that there is going to be someone at the other end willing to buy the crap you’re trying to dump. Until there isn’t.
One day during the crash of the dotcom bubble, I received a friendly margin call from my broker and became one of the forced sellers. I tried to unload my trash first. One of the stocks was a former dotcom highflyer. I’d bought it at a beaten-down price a few months earlier, trying to catch a falling knife. So when I tried to sell it, there were no buyers willing to pay more than a few cents. Liquidity had evaporated before my very eyes, just when I needed it the most.
I was learning the meaning of “illusory liquidity.” But liquidity always magically reappears when the price is low enough. For central bankers who’ve been inflating asset prices for years, and for investors who’ve benefited from these policies, that simple fact is a terrifying thing.
The EU’s top regulator for insurers and pension funds wasn’t kidding when it warned that QE was triggering treacherous “volatility” in the bond markets. “Volatility” isn’t actually the right word. It implies ups and downs. But euro sovereign bonds have experienced a brutal rout. Read… ECB Loses Its Grip, Bond Market Comes Unglued
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I understand how the last two are assets, but the fact that they can be grouped without pause with the 1st three shows how corrupted our western thinking has become under capitalism. Farmland and factories are the heart and soul of a people’s survival and should never be just another line in a portfolio.
You should include homes in your subset. As to the next two, only those with disposable income are able to invest, even in their own future, therefore, the bulk of the 99% are left at the gate.
Homes are still individually owned, whereas factories and farmland really are part and parcel of a community. Homes may take any number of forms. I would rather live in a healthy, safe, happy tent community (hypothetically speaking, since few if any exist at this time in the west) with a solid foundation of farmland and/or factories than in a failing society filled with tract housing or mcmansions where people are isolated and miserable.
I could leave our homes behind theoretically, although I do see your point that at this point in time in the west, these homes are what provide us with our semblance of security and shelter, although they are a two edged sword. We’d be better off without all of these walls between us.
You beat me to it. Homes, too, should be above and beyond mere “assetization”. A home with a yard around it provides the means for some techno-peasant 2.0 subsistence and survival in difficult situations.
may i please borrow your yard?
A 400,000 square foot factory where there is no labor or infrastructure to bring in materials or send goods to market isn’t worth much, and “farmland” in swaths of California are already worthless without water. The fact that all these are interconnected and dependent on larger ecological and economic forces that are playing out (cities where sea level rise will put them underwater, cars where roads and bridges are in dangerous disrepair, homes stranded where jobs have all vanished, places where blight of resource extraction will leave them uninhabitable and unproductive for millennia, etc.) all upturns conventional thinking about what assets are.
Quite right….how many abandoned factories are in Detroit? Thousands.
Does this mean US Treasury bonds aren’t a sound investment?
As you might have guessed, the US government has exempted itself from the legal requirement to publish a prospectus to inform investors of the risks presented by its securities. These risks include illiquidity and Federal Reserve market manipulation.
To answer your question, you will obliged to do your own due diligence. We don’t need no stinkin’ prospectus.
For US Treasury bonds to be a sound investment, they must first be an investment.
If you buy to trade them, I’d suggest holding off. If you buy to protect savings, you’re fine.
I just don’t get this kind of talk. Yeah, if you’re a leveraged institutional player and you need to sell, that’s panic for you, but if you’re Joe Blow holding some munis or whatever over the long term, what does it really matter?
I guess what I’m asking is, in the case of Fed tapering (or not), isn’t policy again being driven by the panicked cries of the Wall St. Cassandras rather than the needs of ordinary investors?
As one of those retirees holding some muni’s for the long term, I hope it doesn’t matter. If it might, someone lemme know a) why and b) how I guard against whatever the threat is.
Thanks.
Munis have, can, and will default. Just knowing they are not “riskless” will put you ahead of 95% of those holding them.
If you’re a joe blow and there is a bust you’ll lose your job, your mortgage rates will spike (leaving you homeless or forced to short sell), inflation will erode every aspect of your quality of living. If you’re a 1%er, you can jet out to your villa in the Caribbean and ride out the storm sipping pina coladas.
your mortgage rates will spike (leaving you homeless or forced to short sell),
meaning you have an adjustable rate mortgage, meaning you’re gambling.
If you’re a 1%er, you can jet out to your villa in the Caribbean and ride out the storm sipping pina coladas.
groan
Fixed rate mortgages are rare outside the US
I think the comment was from a US domestic perspective? That’s he way I read it.
I believe, (it may have changed) that insubstantial mortgage down payments are rare outside of the US. As well, many other countries have higher barriers to companies summarily offing employees, it is a fair generalization domestically (US).
When ever the TBTF banks say the word “liquidity” what they mean to say is insolvency.
TARP 2.0????
Wouldn’t it have come to this anyway? Under our reptilian mindset, without growth there is only austerity. But nobody trusts growth because global warming and peak resources. Corporate earnings are as fudged as the Fed’s unemployment stats. So if the Fed stops being the liquidity of last resort in an economy that isn’t creating liquidity we will not even maintain at their 2% target. Already that one is out the window; even Fed governors and ex-governors are now blaming Congress for fiscal failure. I think Varoufakis is looking straight down this tunnel. Our two choices haven’t changed in eons. Either bad growth projects or austerity. What about good growth projects. Not free market and consumer growth, but 20-year social planning and green stuff. Something tells me there just isn’t enough pork in good growth. Not even for the contractors any more; and not for the corporations looking to make big profits by selling stuff.
You have to understand the extent to which the crooked folks have driven the honest folks out of the game.
Not only do the crooks have no appetite for honest “good growth” , their definition of what constitutes a good business decision explicitly excludes anything that you or I would call “good growth” that is, long-term public sector improvements or anything with a “green” or “sustainable” label.
I’m reminded of the situation of small manufacturers going to banks for money to expand and being told their loan can’t be funded because their business plan does not include a plan to off-shore production to China, and that “requirement” by the lender’s underwriters being the misguided result of believing in fairy tales spun by crooks and right-wing ideologues.
The crooks and ideologues have, for the most part convinced not only themselves, but a good portion of the public the what you call “good growth” is either socialism or soft-headed BS.
The only activity taken seriously is the search for high returns on doing what you or I would see as foolishness, if not evil.
You know, the ignorance of being an “ideologue” goes both ways.
Invoking the “you didn’t build that” fervor…
Just as Industry relies on government vouchsafed infrastructure, subsidies, etc., so too We the People rely on those projects being financed. When all is said and done people tend to be all the fucking same — in most cases either stupid or greedy or both — which is to say that the deeply rooted problems in our economy are principally on a systemic, not individual, level. Pigeonholing everyone doing “business” as “evil crooks”, far from being productive, only makes you sound foolish.
…and putting words in other people’s mouths makes you either dishonest or stupid.
Nowhere did I say everyone doing business was a evil crook.
In fact I’ve stated many times on this board that my hope is that business people wake up and realize that the crooks who rule this mess are not on their side, a fact that is becoming more clear with each passing day.
Do try to be kind to fools (I find myself among them all too often) — even those who put words into your mouth.
Alas, I do agree Fool showed truth in choice of moniker, in this very particular instance.
Repeating a phrase from a favorite movie — I sense a “buried bone.” Rather than engage to your thrust, I hope Fool will clarify what it is which troubles Fool. Tilts at constructed windmills suggest Fool is troubled by other matters. I want to know and understand.
“Tilts at constructed windmills suggest Fool is troubled by other matters.” How awesome did your fart smell after typing this sentence? I want to know and understand.
Huh? Who are these “business people”: the start-ups? their venture capitalist stakeholders? the bankers who underwrite the public offering? the investors who buy its equity? the Activist who urges in the name of shareholder value to consider putting itself in play? the PE guys who take it private (lol)?
Who, then, are the “crooks” with respect to these noble businessmen? Which “mess” is it that you’re referring to exactly? What “side” are you talking about?
Help me out here and then I can apologize for suggesting that perhaps you weren’t so informed about our economy and were simply parroting populist rallying cries…
Individual ideology may not mean that much. If the system requires that you be a bigot, most of us will find some valid reason to excuse ourselves for bigotry or convince ourselves that we are not really acting like bigots.
Same thing with a system that requires that you be prepared to relocate your factory to China. Unfortunately most factory owners are not in a position to send a message to their banker saying FOAD.
If you need a reeducation in how it works, go back and reread “Babbitt”. And when you finish that, compare the character Babbitt in the novel with the common stereotype that has nothing to do with the character Sinclair Lewis created.
Not everyone in business is an “evil crook” but selling out pays better – if you can find someone who wants to buy.
I hate to be the one defending bankers…but come on really? What incentivizes factories relocating to China is our tax code and and weakened labor organizations, among other things. Take it up with your congressman.
No . . . what incentivizes factories relocating to China are Free Trade Agreements, in particular the MFN for China legislation. If we had Protectionism, we could ban imports from countries with lower wages, environmental standards and their attendant costs, etc. Then the factory relocators would have no incentive to relocate their factories to China because under Protectionism they would know that they would be permitted to move zero product from China back into the US.
Free Trade is the New Slavery.
Protectionism is the New Abolition.
perhaps instead of “protectionism” a policy of “don’tdobusinesswithcreepsism” would be more effective.
I stand corrected.
Trying to understand something here:
“Weber blamed central banks for the liquidity issues in the global bond markets. They’ve been buying “vast amounts of assets and putting them on their balance sheets”; not just government bonds but also corporate bonds. Since central banks “buy and hold,” they “take some liquidity out of the market.””
My sense has been that without central banks buying those bonds, they wouldn’t be worth as much, so how can you take liquidity out of a dry lake?
Am I missing something?
No, you’ve got it right.
“…they wouldn’t be worth
as muchanything”How do you do that thing when you scratch through a word?
Something to do with “less than sign, lower case s, greater than sign” and “less than sign, strike, greater than sign” Fool – wait, not calling you a “fool” but…
Me too! Please show the HTML to do that. [Yes — I could search the web and quickly find out how but I’d never be able to finish the rest of tonight’s reading if I did.]
put the word of your choice between the opening <strike>and closing</strike>.It would then look like this:
“put the word of your choice between the opening
and closing” Notice you can’t see the words strike and /strike anymore surrounded by the “less than” and “greater than” signs but instead just see the wordand closing.Instead of “strike” you can just use the letter “s”, just don’t forget to use both the open < > and close </ > portions around the words you want to strike out, otherwise everything following the initial html “open” code will be “striked out” without that “close” code.
One measure of bond market liquidity is “float” or the supply of bonds that are available to trade, either held by dealers or by institutional investors that are seeking to maximize return and will sell them given an attractive price. The greater the float the greater the assumed liquidity in the market and the lower the bid offer spread in the aggregate. When Central Banks buy bonds in QE, they increase the price incrementally (as you say) but they also reduce the overall market float because the bonds are no longer available for sale at any price. By this action, liquidity is reduced.
Leading to a higher bid offer spread? What is this , and is it theoretical purpose of QE, i mean what happens in real time when bid/ offer increases, who is that intended to help and how? Sorry, don’t get bonds, can’t even figure out the whole price/yield thing. So if I buy a bond today, i’ve in a sense created the value, or committed to todays percentage, so say its a 10 yr, over that 10 yrs i can sell the bond any time i want, or wait til maturity at which point I get 10 yrs worth of the accrued 2%?
You can sell your Treasury whenever you find a buyer.
Thank you, Timmy. “The greater the float the greater the assumed liquidity in the market and the lower the bid offer spread in the aggregate.” That seems to go towards both method and motive.
I think the real issue is the mis-pricing of assets. Folk load up on the upswing using the greater fool logic, assuming they can always sell when it begins to play out. When prices start to drop and everyone attempts to sell, they find no one will buy at those inflated prices. And that cascades as they are pinched for cash and start selling stuff people actually will buy, causing a glut that causes those prices to fall, etc.
Here in Socal have seen this very clearly in housing. That freeze in home sales at 1.5 million goes away when banks foreclose and put the house for sale at 900k. And I saw Ferraris get sold when people were unable to sell their homes anywhere need the price they paid.
This isn’t necessarily the opposite of what QE is “supposed” to do. If QE improves the long-term economic outlook, yields *should* go up and bonds *should* go down. If the only way QE affected things was through bond rates, that wouldn’t be possible, but with the Euro a commitment to QE improves the long-term stability of the currency by reducing the risk of major crises.
You really are a fair economist.
‘If QE improves the long-term economic outlook, yields *should* go up and bonds *should* go down.’
Right. But given normal lags, that’s a reaction one would expect to occur over a couple of years, not in a mere three months after the buying began.
This is market manipulation blowing up in the face of the manipulator. Just like the Hunt brothers drove silver to $50 an ounce … and then it crashed and ruined them.
Having burnt his fingers to the bone ramping bunds, perhaps Mr. Draghi will have a go at gold. What the hell — it’s money for nothin.’
It is not like the Hunt brothers. The motives, methods, and desired results of greedy Texans are not the same as a central bank.
As I remember, the Hunt Brothers were also “cheated” by the guys who ran the markets. These were the guys who had sold naked shorts and were about to lose a key part of their anatomy. They changed the margin requirements in a way that took out the Hunts.
There’s really nothing so delightful as a guy that is old enough to remember the Hunt Brothers warning us all about Naked Shorts. Please tell me more…but I’m just telling you right now I am NOT interested in buying any GOLD.
Holy Crap! The Fed Bus is on the Bridge To Nowhere!!!!
All the previous liquidity got “invested” in “illiquid” asset prices.
What now?????
WhoCouldaKnow’d.
I think they’re all bozos on that bus.
Don’t crush that economist, hand me the algorithm.
Home asset bubble thanks to the FED works like this for a good friend.
Purchased home near new Apple HQ 40 years ago for 35K. Home now worth around 1.2M but my friend has borrowed over the years and owes 400K. So they can sell and take a clean 500K and pay capital gains and higher income rates on the left over but to buy a new property anywhere in the Bay area will easily eat there 500K, and RE taxes will run 600 per month plus add an assortment of local property, state and county bound measures and they will have a 1K monthly bill easy. They currently pay maybe 250 a month in RE and related bond taxes. The bottom line is that unless they are willing to move to downtown Detroit or the far ends of Calif far from family and friends they are stuck even though the house may on paper be a big asset in real time taxes and finding alternative living eats up the big profit so to speak. The bigger winner in this time frame is those inheriting property from family as the tax treatment is very favorable for property under say 5M.
The worm in the apple of the real estate ‘wealth effect’ is that 1) RE is not particularly fungible 2) transaction costs are very high , up to 8% for each sale/buy 3) for every sale, you must buy or rent, and these are real costs that have to be allowed for.
This is not to say individuals can not do well, but the monetization of RE equity is not as straightforward as is imagined.
A further note for retirees : a number of friends have sold urban property and moved to take advantage of lower prices, have found it difficult to integrate to new communities.
That problem is as old as the hills mate. Community as a philosophy has been under attack by the Neoliberal Reaction for decades.
Wrong, just wrong.
Proposition 60 transfer of property tax base for senior. Proposition 60 transfer of property tax base for senior citizens on november 4, 1986.
Ehh this sounds overblown. Wall Street fundamentally makes its money off the movement of capital. Bonds have been a rainmaker in this respect: e.g. 30 years ago as an integral ingredient to LBO’s or in the present day of having an abundance of nickels to pick up with the Fed as an always reliable counterparty. But if you’re just Grandma Moses holding the bonds to maturity, liquidity is intuitively less of an issue. Maybe I’m missing something, but the liquidity risk that gets priced in would principally affect market-makers as opposed to run-of-the-mill investors.
As a rule, I’m skeptical of the Street kvetching about how this-or-that will effect the state of the economy as its health is only important to them inasmuch as it affects the profitability of their business. In this case, as I mentioned, their business will suffer. Of course their lobbying efforts are now expressed as concerns for the health of the economy as that appeals to politicians — who on the other hand care about a healthy economy inasmuch as it affects their getting reelected — in the hope that they will loosen up regulation of capital requirements (i.e. more profitability for banks).
My question is: all else equal, how bad will the fallout really be from a lack of liquidity in the bond market (i.e. lower trading profitability) for the economy as a whole?
I think the point of this post is not that the bond market might become less profitable, but the possibility that it may cease to function at all, and thus become a contributor to, if not the epicenter of the next big one.
At that point, while Grandma Moses continues to be unconcerned with the bond market, she longs for the good-old-days when she could afford cat-food.
Totally. And if Grandma had balls she’d be Grandpa.
“Wall Street fundamentally makes its money off the movement of capital”: ah, if Marx was right in stating “capital is the surplus value of labor”, I see now why some labor is “moved” to foreign shores and H1Bs are “moved” to home shores. Not a bad gig if one has capital.
As the Fed allows it’s now $4 trillion bond portfolio to mature, they will be paid for them ultimately by dollars that must come back from the economy(the treasury will sell new bonds to pay off the old…)
The liquidity they pumped in went largely into pumping up non productive asset prices – house prices, “pre-owned” stocks in corporations, bond bubbles, corporate M&A and stock buybacks.
So this will actually create a vacuum which will attempt to hoover up negative liquidity pressure (this is not an official finance term – yet!)
Not this has anything to do with interest rates – only the fact that they did lots of QE. Rising rates has it’s own knock on effects with the leverage crowd.
How that circle squares is a big question in my mind.
Feeling guilty due to the castigation from Yves for not contributing ( I only contributed once during the years I have daily read this blog), why does our government sell bonds at an interest when I can buy them using leverage? Doesn’t that mean I can create capital out of nothing?
Well, some people seem to be doing it.
Yeah, it’s easy, the trick is to start out with a lot.
On the macro scale, liquidity and bonds appear to have a stormy future. What about the very very micro-world of those of use holding Mutual Fund cash accounts? How will/could those accounts be impacted when the macro bonds market stalls? Could a little guy like me by looking forward to Cyprian-style haircuts in our future?
I hope I don’t have to start wearing a crew-cut — or worse — shave my head and get a tattoo “trimmed short by the economy”.
Got a question. Let’s say the Fed decides to set a target of 2% for the Federal Funds rate, by raising it in 1/4% increments over 8 quarters. Rising rates trigger a wave of bond selling, and liquidity evaporates (no buyers, except at steep markdowns). Wouldn’t the Fed simply step in and buy whatever the market wants to sell, at the price required to maintain the Fed’s target interest rate? If so, I don’t see how the Treasury market could ever become illiquid. Unless the definition of “illiquid” means having to sell at a loss, no matter how moderate (e.g., <10%).