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 The financial industry worries that when the Fed's tightening plans
take hold, a sell-off in the massive U.S. bond market could ensue,
and be exacerbated by a lack of bank buyers willing to jump in.
Banks, including primary dealers who act as market makers for U.S.
Treasuries, have slashed bond inventories in the past few years in
response to tougher capital requirements, reducing a liquidity
buffer for the fixed income market.
Private and public comments by Fed officials show that they do not
share Wall Street's degree of concern about liquidity, and do not
believe that capital rules are solely to blame for the bond market’s
growing tendency to seize up.
Effectively, regulators are telling the industry it is the
responsibility of banks, funds and other market players to protect
themselves.
"It's hard to find any financial market player who doesn't talk
about being concerned about potential liquidity issues," Eric
Rosengren, president of the Boston Fed, which oversees many of the
country's largest asset managers, told Reuters.
"So it would surprise me if I found that people were using a
particular model and didn't use any intuition about what goes into
those models, and what might happen if everybody blindly uses those
models."
At last week's congressional hearings, Fed Chair Janet Yellen
resisted pressure by Republicans to acknowledge that new capital
rules were destabilizing markets.
"You see this decline in liquidity in some measures, but not
others," she told senators on Thursday.
The Fed's assertive stance is setting the stage for more volatile
fixed income markets and where liquidity droughts could be the price
of doing business in bond markets.
The message - in public addresses, reports to Congress, and even an
investigation into market turmoil last October - is that less
liquidity is a necessary consequence of regulatory reform and
fitting for an economy that is getting ready for tighter monetary
policy.
Investors cite many causes of market vulnerability: primary dealers
holding far fewer bonds and the Fed holding far more; bans on some
broker proprietary trading; a growing reliance on high-frequency
trading; worries that funds will not have enough assets to withstand
a firesale by clients; and rising volatility, especially in the
emerging markets that could see big selloffs when the Fed hikes
rates.
Overall U.S. bond market volatility has risen 60 percent since a
mid-2014 low, according to Bank of America Merrill Lynch's MOVE
index, which measures the implied volatility of U.S. Treasury
markets - a statistic that underscores liquidity concerns.
BlackRock, the world's largest asset manager, has suggested it was
time to move on and start devising strategies on trading through the
dry patches rather than keep pushing back against tougher
regulation.
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ROUGHER SEAS
"There's plenty of capital there. We need to talk about how that
needs to move from holder to holder," Richard Prager, BlackRock's
global head of trading and capital markets told a financial forum in
May. "We clearly have a liquidity challenge at the moment but we
have to recognize the journey and talk about what needs to be done."
Three Fed governors have recently downplayed regulators' role on the
new dynamic taking over the bond market.
On July 15, the Fed reiterated that stance in its bi-annual monetary
policy report to Congress, when the central bank said it did not see
significant deterioration of liquidity in either the Treasury or the
corporate bond market.
U.S. Treasuries are the easiest debt security to trade globally,
with the spread between bid and ask prices less than a hundredth of
a percent.
But for 12 minutes on Oct. 15, sellers backed away, causing a wild
price swing that sent the yield on the 10-year Treasury up by 0.16
percent and then down again.
In a report on the incident published last week, the Fed and other
regulators found no single cause, while pledging to review firms'
risk-management strategies and monitor liquidity in the market.
What the Fed seems to be telling money managers is that they should
be aware of a possibility of panic selling and a lack of buyers if
all of them following similar risk models.
"I think they want to know that we are thinking about it and
addressing it and I think now we all are," an executive at an asset
management firm, who requested anonymity.
(Reporting by Jonathan Spicer and Michael Flaherty; additional
reporting by Jessica Toonkel in New York; Editing by Tomasz
Janowski)
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