Liquidity can evaporate when it's needed most
An FT article this week termed the recent bond sell-off a taper-tantrum and asked if this might become a full blown hike-huff once the Fed actually raises rates.* We aren’t sure what the correct term is but two papers that came our way recently suggest system-wide risk in corporate bonds has increased as market liquidity has decreased.
The first article is actually a slide deck from the U.S. Treasury that tracks bond market liquidity over the past decade.** Since 2008, the trends are very clear. Increased regulation, including Basel III and 13 other major regulatory changes, strongly incentivise banks to shrink their balance sheets. Specifically, the capital charges for corporate bonds increase 3-5 fold with new regulations. And for every 1% increase in capital, banks can either raise $25 billion of new equity, shed $500 billion of assets or some combination thereof.
Unsurprisingly, investment dealer inventories of corporate bonds have shrunk, but this is at exactly the same time that daily liquidity bond mutual fund assets have hit all-time highs. The two charts below show the confluence of strong mutual fund demand and supply limited by central bank buying. Reversing this will be difficult and it is reasonable to expect sudden dislocations, according to the presentation. In our view, this demonstrates the need to combine alternative strategies with traditional pure-long in credit markets.
Chart 1: Strong Demand
Chart 2: Constrained Supply
The second paper concerns the financial-plumbing of money markets. Manmohan Singh’s recent IMF Working Paper describes how 4-years of QE has affected the global demand and supply of good collateral or “safe assets”.*** Effectively central bank buying shrinks the supply of good collateral, which has driven interest rates down. Reversing this process in an orderly way is made more difficult if banks are shrinking their balance sheets for regulatory reasons.
This is especially true for the longer maturity bonds, which are vulnerable to sharp price declines as rates rise. So, for central banks to manage short term interest rates carefully, the release of “safe assets” will likely be very slow. Interestingly, Singh notes the last three tightening cycles averaged close to 400 basis points. Starting from today’s approximately negative 2% real interest rates suggests a peak Fed Funds rate of around positive 2%. What a far cry this is from interest rate cycles of a decade ago, never mind the 1982 peak.
One surprise in all this is the role of hedge funds. They are the only source of collateral that is bigger and playing a more significant role since the 2008 crisis.
Of the $2.8 trillion of collateral pledged in 2012, $1.8 trillion is estimated to have come from hedge funds, which is why short-sale bans usually have the effect of raising not lowering market volatility. Robert Sloan’s excellent book Don’t Blame the Shorts made this point soon after the recent crisis. The sudden drop of good collateral essentially froze money markets.
In any case, it is fairly clear that taper-tantrums and hike-huffs are possible across all terms of interest rates, from short term to long term. The current calm in markets is probably a good opportunity to make sure portfolio risks match long term objectives. Liquidity can evaporate when its needed most.
Generation Asset Management
**** Sloan, Robert. Don’t Blame the Shorts: Why Short Sellers Are Always Blamed for Market Crashes and How History Is Repeating Itself. New York: McGraw Hill, 2009 (http://www.mcgraw-hill.co.uk/html/0071636862.html)