Negative Rates + QE = Less Liquidity in Government Bond Markets

  • Market depth in German 2-year note futures erodes since 2014
  • Basel III, primary-dealer withdrawals also crimp liquidity

Add negative interest rates to the list of monetary-policy tools hampering liquidity in sovereign-bond markets.

One measure of market liquidity in Europe has fallen by more than half since late 2014, according to JPMorgan Chase & Co. The aberration may worsen as the European Central Bank contemplates pushing rates further into record-low levels. The ECB, whose quantitative easing already removed 595 billion euros ($645 billion) of public and private debt from the market, is forecast to cut its deposit rate further below zero on March 10.

The ECB’s policy tools have crushed yields, eroding government bonds’ appeal for new investors and making current holders less likely to sell. And liquidity is suffering, meaning it’s harder for investors to trade without moving prices significantly.

Market depth in two-year German note futures -- one of the most sensitive securities to ECB policy -- has fallen 56 percent since November 2014, as measured by the number of contracts traded within the three tightest bid and ask spreads, data from JPMorgan show.

QuickTake Negative Interest Rates

“You can’t disregard the impact that the negative-rates policy has had on liquidity in bond markets,” said Nandini Srivastava, a global market strategist at JPMorgan. “That’s likely to persist. Any deterioration in market liquidity indicates investors are less willing to hold or trade these securities.”

From Frankfurt to Tokyo, central banks’ push below zero adds to Basel III regulations, primary-dealer withdrawals and the growth of electronic bond-trading, which have curtailed liquidity in global markets. Less dealer participation removes a buffer that historically curbed price swings, and at a time when more investors are piling into crowded trades.

Japan, Too

In Japan, the world’s second-largest debt market, trading in two-year bonds is so thin that the securities did not open on time for most of February and they did not trade at all on Feb. 23. That means investors are increasingly forced to look elsewhere for bonds that are easy to trade.

The month after the ECB set its first negative deposit ratesin June 2014, investors could still trade 24,073 German two-year note futures contracts within the three tightest bid and ask spreads, based on a five-day average, according to JPMorgan. That number even climbed to 28,947 in November 2014.

Yet as traders grow weary of a market that’s more vulnerable to price swings, the figure has plummeted to 12,680 contracts on Feb. 25 this year, according to the most recent data from JPMorgan.

At the same time, the volume of trading through all dealers has been relatively steady in the last two years, Eurex Exchange data compiled by Bloomberg show. The German two-year note futures contract expiring in March was little changed on Thursday at 111.955 at 10:52 a.m. in New York.

Holding Tight

Some investors that depend on cash flows from higher-yielding securities they purchased years ago don’t want to sell them, said Daniel Lenz, lead market strategist at DZ Bank AG. “That keeps them away from the market,” he added.

Traders have opined that the Federal Reserve damped liquidity in the Treasury market by reducing the amount of bonds available for trading when it scooped up unprecedented amounts through its purchase programs ending in 2014. The Fed is now the largest owner of Treasuries, with a total of $2.5 trillion, and is expected to reinvest proceeds from $216 billion of the securities in its portfolio that mature this year.

In Japan, yields plunged into record negative levels after Bank of Japan Governor Huruhiko Kuroda introduced a minus 0.1 percent deposit rate on Jan. 29. The low levels have forced investors to seek higher yields with longer-term maturities. That helped to push price swings on the nation’s benchmark 10-year notes last week to the highest level since 2013, according to data compiled by Bloomberg.

‘Locked out’

“It’s getting worse day by day,” said Hideo Shimomura, the chief fund investor at Mitsubishi UFJ Kokusai Asset Management in Tokyo with assets of $107.4 billion. “Trading is quite thin, and we can get locked out. There’s no trade some days. If you want to do considerable size, you have to go to the auctions.”

Appetite for the benchmark 10-year Japanese government bond was so strong on Feb. 26 that the yield dropped to a record low of minus 0.075 percent. The result of the BOJ’s bond purchases and other policy measures is that about 70 percent of Japan’s outstanding interest-bearing debt had a negative rate in the secondary market, as of Feb. 25.

“In the near- or mid-term future, there’s no reason to believe there will be a major shift in liquidity,” Lenz of DZ Bank said. “Obviously we cannot escape from the low yield environment.”

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