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