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 The price of German 10-year government bonds plunged this week,
triggering the biggest rise in yield in over two years. Some
analysts blamed the sell-off on a lack of liquidity, with
Commerzbank going so far as to call it a "flash crash".
There was no discernible market instability like a widening of
bid/offer spreads, often a reliable sign of thinning liquidity. But
there have been signs of potential dislocation in recent weeks -- on
one day in March the Bund bid-offer spread blew out to nearly 6
basis points, the widest in three years.
Analysis from GreySpark Partners shows that the average spread in
high grade U.S. corporate bonds since 2011 is around 12 basis
points. In the five years before the global financial crisis, it was
7 basis points.
Liquidity is an amorphous concept and impossible to measure
accurately. Its scarcity is only exposed in times of crisis. But
everyone agrees it is shrinking, and this could dramatically push up
the cost of trading, widen bid-ask spreads and make it harder for
traders to close out positions.
As long as asset prices are rising, as most are thanks to super-easy
global monetary policy, this isn't a problem. But it will be if
there is a sudden reversal and traders are forced to offload assets
only to discover there are no buyers.
"This is a critical problem to the functioning of markets," said
Andy Hill, director of market practice and regulatory policy at the
International Capital Market Association.
"Without secondary market liquidity, primary issuance will be
impaired. We're in a fragile state now," he said, adding that lower
rated corporate bonds, high yield debt and emerging markets are most
vulnerable to a crunch.
The potential for a sudden freeze across a range of markets is a
growing source of concern and debate among global policymakers and
regulators.
They are trying to assess the impact on markets of regulatory
changes that force banks to hold more capital and less inventory on
their books. Financial market participants say this is curbing
banks' trading and their ability to act as market-makers in many
fixed income, currency and money markets.
CARRY ON SHRINKING
There's an important difference between the sea of liquidity worth
trillions of dollars provided by global central banks in recent
years and the dwindling liquidity as measured by market trading. In
some ways, they are two sides of the same coin.
The former is self-evident. As the Bank for International
Settlements said in a recent report, global liquidity is "abundant".
Central banks have printed $11 trillion since 2007, bringing central
bank liquidity coursing through the global financial system to more
than $16 trillion, according to Deutsche Bank. The European Central
Bank is in the process of adding a further $1 trillion and China may
act too.
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But the latter, essentially a measure of the cost and ease of
transacting a particular asset without prompting a huge swing in its
price, is much less visible and harder to quantify.
This parallel trend of rising cash liquidity from central bank
largesse and shrinking market liquidity was outlined in two recent
investment bank reports.
In 2005 the U.S. corporate credit asset universe was worth around $9
trillion, of which 5 percent was on dealers' inventories. These
assets are now worth around $12 trillion, of which less than 1
percent is on dealers' inventories.
"Shrinking dealer balance sheets coupled with bond market growth
have led to a significant worsening of fixed income liquidity,
especially in corporate bonds," Morgan Stanley said.
Primary dealers now hold only around $50 billion of U.S. corporate
bonds on their books compared with $300 billion before the crisis,
according to a study by Deutsche Bank.
In that time the total stock of outstanding bonds has more than
doubled to $4.5 trillion from just under $2 trillion. Lower
inventory means dealers will be less able to match wary buyers with
panicked sellers and smooth out any market volatility.
Factoring in all markets -- interest rates and repo, currencies,
emerging markets and commodities, credit and equities -- Morgan
Stanley calculates that banks' balance sheets shrank by around 20
percent last year and will shrink a further 10-15 percent over the
next two years.
The most obvious shock to markets on the horizon is the U.S. Federal
Reserve's rate hike. When it comes, it will be the first rise in
U.S. interest rates since June 2006. Simply put, there are many
traders who have no experience of the world's most important
interest rate going up.
(Reporting by Jamie McGeever, additional reporting by John Geddie;
Editing by Toby Chopra)
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