Worries about bond market liquidity illustrate little more than the fact that if you remove a subsidy, the price goes up.
In this case the subsidy was from the public purse to banks, and through them to market liquidity as banks tried to make as much as they could from artificially cheap funding and easy money.
As that subsidy is rightly, but painfully, removed, liquidity, the ease of buying and selling in financial markets, has become more expensive, costing something closer to its true cost and risks. That’s a good thing.
Bond market worries have sent shock waves to markets around the world, notably during the “bund tantrum” of April, when 10-year German government bond yields skyrocketed almost tenfold, from just over nothing to 72bp in just over three weeks. Both there and in other instances, strange moves in markets are at least in part due to an unwillingness or inability of financial companies to use their balance sheets to arbitrage imbalances between buyers and sellers, according to the Bank for International Settlements, which Sunday released a study of the issue.
Banks traditionally use their own balance sheets to buy and hold securities for a, hopefully, brief time when markets are out of balance. This can be profitable, but embeds risks which often are not reflected in quarterly profit and loss accounts. New tougher banking regulations make this less attractive for banks, resulting in jerkier movements in markets.
“To be sure, to some extent this may reflect the fact that both funding and market liquidity were badly underpriced pre-crisis,” said Claudio Borio of the BIS, which is often called the central bank of central banks.
“We do not want to go back there. But it is also a symptom of deeper weaknesses. Remarkably, stand-alone bank ratings, which strip out official support, have deteriorated further since 2010 in major advanced economies.”
We certainly don’t want to go back, which is why it is best to heavily discount the widespread complaints of banks that new regulatory burdens are impairing their ability to play their role as financiers.
Also underneath the phenomenon is a desire by longer-term investors to buy insurance against the risks they face based on sharp movements in currency or sustained low interest rates. That sounds like a good idea, but not something which can be done without risk, a risk banks are now less eager to eat.
Swapping out
According to the BIS the volatility in bund markets had its origin in derivative markets, where there has been very atypical movement in the cost of interest-rate swap markets, in which investors exchange a floating rate government yield for a fixed one of the same length of contract. The cost of options to buy a swap contract for a future date rose threefold from January to April 20, ahead of the bund tantrum.
While this kind of price action often shows worries about the health of banks, as a swap carries with it the risk that the bank counterparty might not make good, this time the BIS thinks it may have been the result of long-term investors wanting more swaps than banks had appetite to provide.
“Such volatile movements in euro area interest rate derivatives markets raise questions about smooth pricing responses in the face of possibly transient order imbalances,” according to the BIS.
Bizarrely, in US swap markets spreads are strongly negative, implying that investors are demanding no premium for the risk of doing business with a private bank rather than a government. Here the root cause seems to be sales of US Treasuries by foreign central banks, quite possibly by China seeking funds to meet currency outflows. That’s swamped banks with Treasuries, who not only don’t want to use balance sheet capacity to hold more but also aren’t happy taking the risk of arbitraging what seems a very low-risk anomaly.
I’d venture that the point here is that imbalances aren’t always transient and banks should price them as if they are. Long-term investors seeking safety are asking for a valuable service, and banks need to price that service to reflect its risks. Jerky movements in derivative markets now and again will be a small price to pay for a more stable banking system, one which implodes the global economy with less damaging frequency.
To be sure, illiquidity will slow economic growth, but that’s a trade-off. Banks will ultimately repair their capital, and may take more risk at reasonable rates.
The post-crisis world may feature more volatility, but less volatility of the truly destructive kind.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
