Suspected Sign of Bond-Market Illiquidity Rejected by Fed

Updated on
  • Central-bank researchers say dealer holdings in historic range
  • Corporate-bond inventories tied to outlook for gains, they say

If you’re pointing to declining corporate-bond holdings by the Federal Reserve’s primary dealers as a warning sign of illiquidity in bond markets, you’re off base.

That’s according to research by Federal Reserve Bank of New York, which counters an argument made by market participants from Goldman Sachs Group Inc. to JPMorgan Chase & Co. that a drop in corporate-bond inventories by the Fed’s 22 dealers is an omen of tougher trading ahead. Fed researchers say dealers’ holdings are well within the historical range of the past 25 years.

They offer another answer to why the world’s biggest bond traders are holding fewer corporate bonds: they don’t expect to make any money off them right now.

"The share of balance sheet allocated to debt securities is counter-cyclical: it rises with expected returns, and hence declines as asset valuations increase," researchers Tobias Adrian, Michael Fleming and Erik Vogt wrote in a blog post on the New York Fed’s website. "The tight link between dealer positions and expected returns has returned."

‘New Normal’

Corporate-bond inventories have plunged since the financial crisis as tougher regulations made it more expensive for banks to hold riskier assets, a dip that has led Goldman Sachs analyst Charles Himmelberg to expect a "new normal" of illiquidity. As the Fed prepares to raise interest rates for the first time in almost a decade, the concern among traders is they’ll increasingly have trouble transacting in large blocks of bonds should investors flee the market.

After falling below zero in October, primary dealers’ holdings of corporate debt have risen to $5.3 billion. That’s still less than half the $13 billion as recently as May, according to data compiled by Bloomberg.

The Fed researchers, however, said dealer balance sheets over the past quarter-century rise and fall depending on expected fixed-income returns.

To gauge expected returns in the Treasury market, the Fed used the 10-year term premium, or the compensation demanded for unexpected changes in rates or inflation over the next decade. By their logic, a high term premium would indicate low valuations for U.S. debt, and a low term premium would indicate high valuations.

That metric hit its lowest level since the 1960s early this year, as a global deflation scare and expectations for European Central Bank bond-buying prompted a rally in long-term U.S. debt. Thus, lighter corporate-bond inventories should be expected.

"A long term perspective," the researchers wrote, shows dealer inventories "reflect dealers’ risk management and proprietary trading activities."

(Updated with chart.)
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