Bond market liquidity crisis remains on the table

Anything is possible but not everything is likely. An impending bond market liquidity crisis combined with softening inflation was once thought a remote possibility. No more.

Walter Bagehot argued in 1873 that the role of a “lender of last resort” during a financial crisis is to lend freely to its dependent institutions, but only at penalty rates, and only when good collateral is offered. Institutions that cannot survive under this regimen are allowed to go under. He had a low opinion of “too big to fail,” a problem he described 160 years ago.

Bagehot might have been interested in two storylines that emerged in the last couple weeks on inflation, interest rates and the bond markets.

Storyline 1 was set off by a September Euromoney report by Peter Lee – a liquidity crunch appears to be developing in the bond markets. Now, the term “bond fund crash” is not one to be employed loosely in financial circles. Neither does one like to hear “the great bond liquidity drought” thrown about. The Euromoney story was picked up by everyone from Felix Salmon at Reuters, to Deus Ex Macchiato, to FT Alphaville’s Izabella Kaminska, who hinted of “immobile dark inventory stores” of debt in a delightfully sinister tweet.

U.S. credit mutual fund assets versus dealer inventory

The alarms may be well-founded and credible, but none commented on Storyline 2, which was the cover of The Economist U.S. edition – the fall of inflationary pressures and the specter of deflation in the U.S. and Eurozone economies.

Each on its own is a frightening tale. Combined, they portend real trouble. Could a liquidity crisis push the Eurozone or the U.S. into deflation? Is there a risk of both occurring?

At present, the value of U.S. credit mutual fund assets (holding investment grade and high yield debt) outstrips the value of all broker dealer inventory in the bond markets by about $830 billion (See the Citi Research chart to the left). If for some reason interest rates were to rise, those stampeding for the exits would find the broker dealers, whose role is to make the secondary market in bonds, unable to provide liquidity.

Given the increased liquidity premium that would result, rates would rise more, leading to even greater selling pressure. Under these circumstances, central banks could find it difficult to hold the zero lower bound. Unless someone provides liquidity, a vicious cycle would ensue.

The following chart from the St. Louis Federal Reserve shows the consumer price index for the U.S. and Europe for the last ten years. Japan’s numbers are thrown in for sake of comparison. You can see why The Economist is concerned inflation is stalling out.

CPI All EU and Japan

So what might happen if a liquidity crisis in bonds leads to deflation?

In this scenario, the drought would cause liquidity premium to rise. If deflation were to follow, inflation premium would become negative. If liquidity premium rises to the same extent inflation premium goes negative, the net effect is zero. But there is likely some lower limit to the deflation rate. The same is not necessarily true for the liquidity premium, which could be hefty if a drought threatens.

We would expect interest rates to rise overall and bond prices to continue to fall. Because it reduces the value of cash flows debtors use to pay off creditors in the future, inflation favors borrowers. Deflation, however, reduces credit demand. Why spend now when prices are falling and debt is getting harder to pay off?

Basically, a credit crunch could follow. This time around, borrowing would not be easy, even for sovereigns. Why? First, sovereigns will find it difficult to roll over their debt when it comes due.

Second, for risk-free debt like U.S. Treasuries, the liquidity premium and default risk premium are believed to be zero. Ordinarily, these are charged only to more risky corporate debt. But these are not ordinary times. An article in the Summer 2012 issue of The Journal of Fixed Income concluded that a default risk premium is now attached to U.S. Treasury debt. No doubt a liquidity charge would be levied against “risk-free” debt during a liquidity drought.

Before the Great Recession, risk-free debt was considered risk-free because liquidity premium (LP) and default risk premium (DRP) were zero. The spread between the risk-free rate and a risky rate used to be absolute:  LP + DRP. But now we are talking about the relative difference between the risk-free rate’s LP + DRP and the risky rate’s equivalent. What’s the distinction then between risk-free debt and risky debt if LP and DRP for both are greater than zero? The essence of “risk free” would evaporate.

Would we find risky corporate debt carrying lower interest than supposedly risk-free debt? Indeed, this has already occurred. The FT pointed out in 2011 that 70 American corporations enjoyed lower borrowing rates than the U.S. Treasury did at the time.

Which brings us back to Bagehot. If the secondary market cannot provide liquidity, bond investors (Blackrock and Pimco are the biggest) would be forced to sell assets at deep discounts. Not all bond funds would have good or sufficient collateral to offer and some would fail. Falling bond values would impact almost all investment portfolios and other asset classes, from mutual funds to pensions, from insurers to bank collateral. Meanwhile, rising rates would lead to a general decline in the value of other assets, deepening deflationary pressures and the most sound collateral, sovereign debt, could be burdened by both default and liquidity premia.

How long until the lenders of last resort get involved, especially if the contagion cannot be contained? Bagehot’s advice was ignored during the last financial crisis. We have witnessed the results. Bagehot cannot be ignored any longer.

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Categories: Finance, International

Author:Steven Slezak

Steven Slezak is on the faculty at Cal Poly in San Luis Obispo, California, teaching finance, strategy, and risk management. His research is supported by the university’s Farm Credit Program in Finance and Appraisal. Previously, he taught financial management and financial mathematics at the Johns Hopkins University MBA program. He holds a degree in Foreign Service from Georgetown University and an MBA in Finance from JHU. He has worked in fields as diverse as international economics, national security, commodities trading, and risk management. He consults on business management and strategy.

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4 Comments on “Bond market liquidity crisis remains on the table”

  1. BRUCE ARAMS
    November 20, 2013 at 12:46 am #

    Hey Steven great article ! I have read it a few times and probably only understand half of it. But it is a very scary scenario !

  2. January 6, 2014 at 10:13 pm #

    Bruce: Thanks. Don’t worry, I only understand half myself. Let’s hope we don’t have to develop a better understanding through experience!

  3. March 31, 2014 at 1:46 pm #

    I pay a visit daily some web sites and information sites to read articles, except this weblog offers
    quality based posts.

    • April 1, 2014 at 4:12 pm #

      Bobby:

      Thanks for the comment. I hope you will become a regular visitor to GRI.

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