The Scariest Word in Bond Markets Is Also the Least Understood

Fed Chair Janet Yellen
Janet Yellen, chair of the U.S. Federal Reserve. Photographer: Andrew Harrer/Bloomberg

Who isn’t worried about a lack of liquidity in bond markets these days?

Wall Street’s biggest banks are concerned that new rules have made it difficult for them to buffer against bond price swings. Investors say that makes it almost impossible to determine the worth of their holdings at any given time, much less get out of them. And Federal Reserve officials are saying that the changing structure of debt trading could threaten financial stability, per their comments released this week.

The problem is, it’s hard to figure out exactly what anyone means when they say “liquidity,” let alone how it’ll spur financial Armageddon. Yes, it may take longer to execute bigger bond trades than it did before the 2008 crisis as banks reduce their inventories to comply with new regulations. And, yes, everyone has crowded into the same trades, scooping up risky assets in search of that extra basis point of yield amid unprecedented central bank stimulus.

While that sounds like a recipe for another collapse of the financial system to a lot of people, Jim Vogel, an interest-rate strategist at FTN Financial, isn’t so sure.

Fed Worry

“The cost of liquidity has shifted to large investors, and they don’t like that at all -- whether it’s wider bid/ask spreads or having to sit with more cash,” Vogel wrote in a note Thursday. “Not wanting to pay the cost of liquidity doesn’t elevate it to a systemic issue.”

He’s not alone in questioning the way this more difficult bond-trading environment may or may not cause the next credit seizure. Yet the collective hand-wringing is drowning out those who aren’t advocating panic.

In testimony this week, Fed Chair Janet Yellen noted that market participants “have raised concerns that market liquidity may deteriorate during stressed conditions, citing factors such as advances in electronic trading, increased competition, and new regulations.”

Last month, JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the October volatility was a “warning shot” to investors and the next financial crisis could be exacerbated by a shortage of Treasury securities.

Trading has certainly failed to keep pace with the rapid expansion of the debt. Volumes in U.S. Treasuries have actually fallen since 2007 even as the pool of outstanding debt almost tripled.

Volatility Rise

Many analysts have blamed the lower trading activity on a reduction in banks’ inventories traditionally used to facilitate buying and selling.

As prices have started to swing on prospects for a Fed rate increase and growth prospects in Europe, Krishna Memani, chief investment officer at OppenheimerFunds, says analysts are getting confused.

“What they’re calling bond-market illiquidity is really bond-market volatility,” Memani wrote in a May 14 note. “Dealers don’t make a market liquid, investors do.”

While brokers making markets can speed up some trades, they aren’t a panacea in a rapidly plunging market, according to Memani.

What’s happening now is the return of some price action after years of record easy money policies, he said. Expectations for volatility in Treasuries have surged 40 percent this year from the same period last year, according to the Bank of America Merrill Lynch Option Volatility Estimate MOVE index.

One thing is clear: There’s a lot of concern that we’re careening toward a new chapter in credit markets that has the potential for some serious pain. Whether it stems from a lack of liquidity, however you may define it, is up for debate.

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