Stop me if you’ve heard this before: People are worried about bond market liquidity.
Back in March, Oaktree’s Howard Marks wrote the memo read ’round the investing world that set off what has now been over six months of seemingly non-stop concerns about bond market liquidity.
The point Marks made in his original memo is that liquidity is not merely a facile measure of how easily you can sell an asset. Liquidity is how easily you can sell an asset under some sort of distress without taking a huge loss.
As Marks formulated this, “Most liquid assets are registered and/or listed; that can be a necessary but not sufficient condition. For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.”
We later followed up with general concerns from market participants about just what liquidity is. And now, several months later, the answer is on the one hand more clear but on other hand less so.
Concerns about liquidity, particularly bond market liquidity, began to percolate in the minds of investors after the “flash crash” in October 2014 that saw the US 10-year Treasury note fall 34 basis points – or 0.34% – in just minutes. Liquidity concerns then made their way to the stock market in late August when the Dow fell 1,000 points in just minutes on the morning of August 24 on a startling lack of news.
- NY Fed
JPMorgan CEO Jamie Dimon later called this the kind of event that is supposed to happen “once in every 3 billion years or so.” And so while other commentators like Larry Summers thought this characterization was more of an indictment of JPMorgan’s risk model than anything else, the point is that no matter how you characterize the move in Treasuries last year it was very, very large.
And so the latest voice we’ve heard from on the liquidity front is John Burbank, the chief investment officer of $4.1 billion Passport Capital. Simply put, Burbank is worried that when there is another financial event that forces a number of market players to sell a lot of stuff quickly, there won’t be anyone on the other side of the trade.
This is a worry that was discussed during a Fed meeting back in January.
Burbank’s concerns are also not dissimilar to those expressed by Goldman Sachs’ Steve Strongin back in August, who lamented the government-mandated increase in the size of bank balance sheets as measures that make these institutions more prepared to survive a crisis but less able to help in a crisis.
The basic worry here, from Burbank and Strongin, is that because of the mandated increase in cash holdings on bank balance sheets and a decline in the amount of Treasuries held by these institutions and other primary dealers – lots of which are held by the Federal Reserve following its three rounds of quantitative easing carried out after the crisis – markets could be heading for a rush to the exit in the bond market without ample available buyers.
In this scenario yields would spike and the capital losses would be substantial.
This chart from Deutsche Bank basically sums up the worry about liquidity. As you can see, dealers – or the folks who are matching buyers and sellers – simply have less inventory to smooth out the gaps between buyers and sellers during times of stress.
- Deutsche Bank
The problem is that while certain formulations of the idea of liquidity are narrow and absolutely cause for concern – because again, the yield on the 10-year Treasury note, one of the most liquid securities in the world, doesn’t just fall 34 basis points in less than an hour unless there is a problem with market structure – the term has now become a catch-all for something not dissimilar to admitting that your portfolio is perhaps riskier than you’d intended it to be and that it now seems like you’re going to have a hard time getting out whole.
As Mark Dow put it, “liquidity” is now similar to the use of “leadership” in politics, a vague bromide that sounds important and official, but actually means something different to each person using the term.
In this way we’re all using liquidity as a way of talking past one another to avoid giving specifics about what it is we’re worried about.
This week, the New York Federal Reserve wrapped up a six-part series on bond market liquidity.
Their final installment, published Friday, addressed the idea of a “liquidity mirage” that appears to offer investors a “deep book” against which to trade, only to find out later that their orders were fragmented across several exchanges and arbitraged by high-frequency traders. This ultimately leads to trades being executed at worse prices than previously anticipated.
Peter Tchir, a strategist at Brean Capital, has called this “faux liquidity” and said the market is suffering from an abundance of “air pockets.” Tchir’s example of how markets work in this scenario is that bids, or people looking to buy securities, are sharks, while asks, or people looking to sell securities, are like minnows, sitting in a dense cluster until the shark gets near before scattering.
- Morris MacMatzen/Reuters
But, of course, no matter how the market is structured, at a certain point a large bid is going to move the market. This is kind of the size problem that some hedge funds may find themselves running up against.
But if we’re talking about the US Treasury market – which most of the work on this done by Wall Street and the New York Fed is doing – we’re talking about the largest, most liquid bond market in the world. In theory, it should not be a problem getting a bid within a reasonable range in this market.
But, as Business Insider’s Matt Turner wrote in August, it seemed that at a certain point folks stopped being all that worried about bond market liquidity. Bloomberg’s Matt Levine, in contrast, writes about worries over bond market liquidity every day.
- NY Fed
So it seems that where we stand is that liquidity issues have either been abated – which seems unlikely: Fundamentally nothing about market structure has changed in the last six months – or that people have gotten tired of worrying about bond market liquidity. (This seems more likely.)
Another option is that we’re at the point in the cycle when “worries about bond market liquidity” are in a “show-me” phase.
That is, if I’m a market participant or commentator or regulator or just somebody paying close attention who is not yet convinced that bond market liquidity will usher in the end of the world (or crippling losses), I will simply not be swayed by concerns that a lack of bond market liquidity will take the whole system down until it happens.
Said another way, someone in this state of mind is willing to bet on the continued operation of human civilization against a lack of bond market liquidity bringing the whole project to a halt.