Liquidity risk in the global bond markets is peaking at the worst possible time. It’s not simply an inconvenience for Greek bank customers emptying ATMs; a number of other trends have been building for a while that have bond investors worried.
The liquidity problem has been brewing for almost two years, but now the situation is exacerbated by a shortage of suitable risk-free assets, high volatility levels, and a generation of traders who lack experience trading into market conditions driven by expectations of rising rates. Brookings recently posted a good primer explaining the liquidity issues involved today.
Back in November 2013, I posted a piece about bond market liquidity drying up. A lack of liquidity, I argued, coupled with a strong deflationary trend, could indicate conditions exist in which so-called “risk-free assets,” such as US Treasuries or German Bunds, would no longer be considered truly risk-free.
I cited an article that concluded US Treasury returns were carrying a default risk premium component, and I surmised a liquidity premium might be on the horizon.
The good news is the deflationary threat seems to have passed for the most part, though the UK is an exception. The chart below from tradingeconomics.com shows that deflationary pressures have eased a bit in the US and the Eurozone:
But bond market liquidity has worsened over the last 19 months, as seen in this Deutsche Bank chart. The ratio of US Treasuries held by dealers to the total marketable US Treasuries outstanding has dropped by about a third.
With the US getting ready to raise rates as early as January, a “world (that) has become hooked on […] free money and quantitative easing,” as Rod Davidson wrote in Investment Week, is bulking up on cash and fearing for the worst. It’s “Katie bar the door” when rates start to rise.
The German Bund was long considered a suitable risk-free asset. Until 2012, Bund 10-year yields tracked closely those of their American cousins. But that is no longer the case. The spread between the Treasuries and Bunds has diverged since then and only grown wider:
A recent sell-off in the 10-year Bund has narrowed differences a bit (interest rates rise when bond prices fall, and vice versa) but at around 155 basis points (basis points – bps – are interest rate increments of 0.01%), the spread is still at levels not seen in three decades, according to CNBC.
The sell-off of German risk-free debt began in mid-April and continued through much of June. Bund volatility skyrocketed, as shown in the following chart from the Financial Times:
Eurocurrency volatility has been on a steady rise since July 2014, so in a sense the contagion has spread from the currency markets, where it is not unusual, to the German bond market, where it is not welcome. The implications are important: German debt serves as a financial foundation for the Euro just as Germany serves as a banking and political foundation for the Eurozone.
As a result, JPMorgan is reported to be adding a liquidity premium to highly-rated, longer-term European sovereign debt. Investors may once again be underpricing risk and many are rewriting their trading models to make up for obvious shortcomings. This includes BlackRock, the world’s largest money manager.
Clearly, currency and debt market gyrations undermine the Bund’s status as a “risk-free” asset. So where is the market to turn for an accurate indicator of risk-free returns? No one really knows. Compared below are volatility rates for US Treasuries and Euro futures. Treasuries are still considered a relative “safe haven” to park money, but they have not re-claimed their risk-free status.
That volatility is peaking, at least in Eurocurrency markets, evident in the volatility surface calculated by Bloomberg for 17 June (below). A profile of the volatility curve can be seen in the right-hand panel. The profile shows that volatility in the near term is highest across all expiry dates out to 10 years. For 30 days, volatility is in the red zone as seen on the facing surface.
Anticipated Federal Reserve rate increases will reduce the value of outstanding US Treasury debt, increasing volatility in Treasury markets. To protect against this move, bond investors are pouring into Treasury derivatives. Bloomberg Professional points out, “everyone is trying to shield themselves before the Fed starts lifting borrowing rates.” Again, these are not characteristics normally associated with the world’s premier risk-free asset.
Time to Place Your Bets
Surely, markets should be able to manage this combination of illiquidity and high bond volatility without an adequate supply of suitable risk-free assets to fall back on in an environment of the first rate increases in seven years. What can go wrong?
“Being a Master of the Universe once meant something. Those days are over.”
─ Mark Rzepczynski, the chief investment officer at AMPHI Capital Management
Trading is a young person’s game. Fully two-thirds of traders on Wall Street have less than ten years’ experience at their desks. How are they going to perform come January if rates start to climb?
The following chart shows 30% of Wall Street traders have been working for less than five years. All they know are rates near zero percent. Another 36% of traders have been working between five and ten years. For most of their careers, rates were either falling or near zero. They await a “trial by fire,” says BloombergBusiness.
With rates set to rise, a shortage of bonds available to trade, volatility at record levels, a majority of traders possessing less than a decade’s experience, and with the Eurozone staring into an abyss, the young generation of Wall Street traders are not alone.
