Two weeks ago we warned of the "unintended consequences" of Dodd-Frank which are likely to crush bond market liquidity. On the day of Brexit we got a glimpse of what can happen when the world's most liquid bond market suddenly isn't and as one veteran bond trader exclaimed today, US Treasury market liquidity is "worse than Brexit."
Following the worst two-week loss for bonds... ever...
The bond-market rout triggered by Donald Trump’s election victory has also crimped investors’ ability to trade, according to a Bloomberg index measuring how much U.S. government-bond yields are deviating on average from a fair-value model. By that measure, the deterioration of liquidity in Treasuries has been the most severe since the U.K.’s June vote to exit the European Union...
As we warned earlier in the month, a growing volume of bond trades are circumventing market makers altogether. As Bloomberg points out, the volume of bond sales being "crossed internally" (i.e. sold between different entities that are ultimately owned by the same parent company) and growing rapidly which is serving to further exacerbate the lack of liquidity in the $100 trillion global bond market.
Proponents of internal crossing -- as the practice is known -- say it can reduce costs, while detractors say it’s riddled with potential conflicts of interest and is exacerbating the decline in bond market liquidity. The trades are on the rise at funds including BlackRock Inc. and Legal & General Investment Management, which now trades more with itself than any other firm. The trend is the latest sign of a shift of assets and influence to the buy side from the sell side.
“Asset managers are getting bigger, so they are increasingly crossing internally,” said Elizabeth Callaghan, London-based director in the secondary markets group at the International Capital Market Association. “Where is all the liquidity? It’s sitting in their back garden.”
Internal trading at LGIM has grown to account for about 20 percent of the firm’s fixed-income trades, according to a person familiar with the matter. At Standard Life Investments it’s increased to about 8 percent of deals, said head of trading Steven Swann. At Union Investment it’s risen to more than 10 percent, said Hock.
The growth of the practice is a product of the increased might of the buyside in the $100 trillion global bond market as well as a recognition it’s becoming more difficult to trade as dealers pull back.
“If we sell a bond to the market and try and buy it back, the cost will be higher and we’re not sure we can get hold of it again,” said Yann Couellan, Paris-based head of trade execution for fixed income at AXA Investment Managers, which oversees 679 billion euros ($755 billion) of assets. “It makes sense for us to keep the bond internally.”
Unfortunately, while this practice may help alleviate some of the liquidity issues for large investment managers created by Dodd Frank, it only serves to further limit market transparency which can only be bad news for their clients.
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In June, we asked what is making markets prone to pockets of illiquidity...
Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the ‘same way round’ to a much greater extent than previously. The post-crisis increase in correlations, which has been visible both within credit and equities and across asset classes (Figure 35), stems directly from the fact that investors now increasingly find themselves focused on the same thing: central bank liquidity. Every so often, when they start to doubt their convictions, they find that the clearing price for risk as they try to reverse positions is nowhere near where they’d expected.
This explains why the air pockets have not just been in markets where the street acts as a warehouser of risk. It explains why they have occurred not only in the form of sell-offs which could have caused multiple market participants to suffer from procyclical capital squeezes. It also explains why the catalysts have often, while often trivially small, have nevertheless been macro in nature, since they have boosted expectations of a change in central banks’ support for markets.
Unfortunately, it leads to a rather ominous conclusion. The bouts of illiquidity will continue until central banks stop distorting markets. If anything, they seem likely to intensify: unless fundamentals move so as to justify current valuations, when central banks move towards the exit, investors will too.
Rather than dismissing recent episodes as relatively harmless, then, we are supposed to worry how much larger a move could occur in response to a more obvious stimulus. While financial sector leverage has fallen, debt across the nonfinancial sectors of almost every economy remains close to record highs, meaning that the potential for negative wealth effects in the real economy is very much there.
In principle, markets could gap to a point where they went from being absurdly expensive to being absurdly cheap, and then – as investors stepped in again – gap tighter, perhaps even without very much trading. But the existence of the feedback loop to the real economy means that the fundamentals tend also to be affected by extreme market moves: “cheap” may be a moving target. This in turn could force central banks to step back in again.
To sum up, we are left with a paradox. Markets are liquid when they work both ways. Market participants, though, find themselves increasingly needing to move the same way. This is not only because of procyclical regulation; it is also because central banks have become a far larger driver of markets than was true in the past. The more liquidity the central banks add, the more they disrupt the natural heterogeneity of the market. On the way in, it has mostly proved possible to accommodate this, as investors have moved gradually, and their purchases have been offset by new issuance. The way out may not prove so easy; indeed, we are not sure there is any way out at all.
And sure enough, the last two weeks have seen not a sudden demise in liquidity - as per Brexit - but a steady and serious one-way detrioration in liquidity, as our trader said, "this is a fuck's site worse than Brexit... any size is moving markets drastically, and the machines just make it worse."
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