People Are Worried About Bond Market Liquidity
bloombergview.com
bloombergview.com
In a normal interest rate environment, bonds are income producing instruments and if you don't need to sell and are ok with the interest rate, liquidity doesn't matter quite so much. However with near-zero rates for the last 5-6 years, bonds are only making money as long as there is actual deflation (which however increases default risk) or if yields keep dropping (which beyond zero becomes some weird sort of Einstein-Bose finance where people pay others for the privilege of lending them money). In this type of environment you can't just hold the bond to maturity and live off of the income... to cash out you must sell, so liquidity is critically important.
The "flash crash" rhetoric in the article is a red herring. Much more troubling would be an actual fundamental shift in the market... the bonds markets are so huge that even small moves could prove to be seismic...
I've always thought that preventing this was the true purpose of QE, and is the reason that the Fed quadrupled its balance sheet with little effect on the headline CPI or other mainstream measures of inflation... however it might not be a stretch to say that the hyperinflation that all the doomers were predicting is playing out in the bond markets. If that is the case, and the liquidity dries up because QE is over and everyone who was frontrunning the Fed decides to cash out... yikes
What I meant with my comment is that perhaps the goldbugs were right about the problem but wrong about the effects and that the orthodoxy is wrong that everything is ok++ and there is nothing to worry about.
Here's some dots to connect if you want to deduce my line of thought:
https://research.stlouisfed.org/fred2/series/DGS30 (change the time period to 'Max')
http://research.stlouisfed.org/fred2/series/WALCL
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=newsse...
While its not preferable that QE creates real estate or stock market bubbles, it is preferable to have the bubbles there instead of commodities people need to live (oil and food).
So why is no-one doing this?
Putting aside whether that'd be a good idea or not, government money is generated via the bond market. All new money in the US is generated via the bond market. Therefore, you can't use printing money as a way to stabilise the market that generates it.
In any case I'm more thinking about equity markets - are there even flash crashes in treasuries yet?
[my emphasis on "when"]
I think the "when" is a huge part of the puzzle. How can an algorithm know the difference between a flash crash that will get remedied within 24 hours vs a longer period of irrational pricing that takes months to sort out?
For example, at the time of the famous LTCM downfall[1], it held several arbitrage positions that were eventually proven right... but they didn't have sufficient capital reserves to survive the short term irrational spreads (Russian default, flight to US Treasuries, etc). I'm not saying that LTCM didn't have many other flaws of risk analysis that would have also caused their downfall but in that one case, it was an illustration of "the markets can remain irrational longer than you can remain solvent."
[1]http://www.amazon.com/When-Genius-Failed-Long-Term-Managemen...
Of course, especially these days in the markets, whatever can be leveraged, will be leveraged...
Any company capable of exploiting a flash crash in the way you describe would need to be a timing arbitrage player -- and that's not a cheap business to be in. But exploiting short term dips in pricing is exactly what that type of HFT is designed for. It's incredibly profitable, but also zero-sum because there are only so many lucrative opportunities. So it's an arms race to have the fastest systems, the fastest connection to the exchanges so you can preempt orders, etc.
And arbitrage is always zero-sum: when your purchase of an asset drives the price of that asset up, there is a finite maximum on the number of shares you can buy without driving the price up so high as to not be profitable. There is also a finite number of shares out for bid at any given time; if you buy all of them then there aren't any for anyone else to buy.
No more pets.com because no more floats.
When was the last time you heard about a small operation with little revenue, no profits and not much of a business model getting floated ?
These days it just doesn't happen much. The floats are all giants like Facebook. Back in the late 90s these things were listing monthly.
Liquidity for US Treasuries may well be lower because the Fed's taken so many of them onto its balance sheet[1] but I don't think that a lack of liquidity is going to pose a real problem in that market. There's a difference between a market that's dislocated (by which I mean that the market price has deviated from the "real" value of the asset) due to a structural problem (like a lack of liquidity), and a market that has reached its peak (and/or is overvalued, and is undergoing a correction - which may be happening in Europe at the moment[2]).
People get all excited about flash crashes and talk about billions of dollars being wiped off the value of whatever but it's complete horseshit. Just because a few trades happen at an unreasonable price because of a technical hiccup (or because of some strange, unforeseen interaction between different automated systems) doesn't mean that the underlying value of the asset in question has changed. If a share starts the day at $100, dips to $1 because of a flash crash, then recovers to $100, what has really changed? A few people may have made/lost money by being lucky/unlucky enough to have traded at an incorrect price (e.g. because a stop-loss got triggered or something) but other than the appearance of an icicle-shaped spike on a chart, it's just noise (and if you have a system which reacts to noise, then the problem lies with your system, not the market).
Personally, I think the bond market has been propped up by "quantitative easing", which has, in turn, inflated the equity markets. At some point, that situation has to undergo a correction and that could well manifest itself as a crash if everyone dashes for the exit at the same time. But that's the nature of markets - they fluctuate, sometimes wildly.
1: https://research.stlouisfed.org/fred2/series/TREAST
2: http://www.ft.com/cms/s/0/3722d4a0-0a63-11e5-82e4-00144feabd...
Talk to any face to face financial advisor and they will tell you to buy bonds not bond funds. (You never hear this in the financial press, funny...). The issue is that bond funds don't behave much at all like bonds do because they are always trading to keep the maturity distribution constant. This in turn throws off the logic behind the idea that at age X you should have Y percent of bonds and Z percent of stocks.
If you are doing the "put $50 a week in your IRA" thing, you can't even buy bonds because the denominations are way too large period, but it is even worse if you want diversity.
I'd love to see some kind of ETF with an expiration date that would behave like a bond, give diversity against default risk and be denominated to be a tool for the ordinary investor.
Trouble is it is hard to get anybody excited about bonds today and if interest rates ever go up, bond funds will be a bloodbath -- PIMCO will lose more money for investors than anyone in history, not because they did anything wrong but just because that is how the cookie crumbles.
With that backdrop it might be 25 years before people will buy a new debt product.
Don't necessarily agree with your assessment on rates but yeah hard to get excited about bonds right now.
They actually already exist: http://guggenheiminvestments.com/products/etf/bulletshares http://www.ishares.com/us/strategies/ibonds
They're not super-liquid, but they exist.
Obviously the downside of this is that you are basically keeping your principal value at the end of the day, but you're forced to hold a bond that's giving you a below market return until it matures. For most people, this makes absolutely no sense.
On top of that, you can buy and sell a mutual fund based on the asset value of the fund at any time, while the bond market is opaque and you often get pricing that is very far off the average unless you are a large institutional buyer/seller. There are massive economies of scale in bonds that you don't see in the stock market.
If you are trying to invest millions of dollars, buying individual bonds might make more sense, but at that point you're going to want someone to help you determine the difference between individual bonds and the covenants that one bond has over another, but even then you still run the risk of getting bad pricing on buying those bonds.
Bond Rout Wipes Out 2015 Gains as Traders Stay Glued to Screens
http://www.bloomberg.com/news/articles/2015-06-03/bond-rout-...
Bill Gross of Janus called German Bunds the "short of the century" and it looks as if US and JPY are equally vulnerable. $TLT down 15% since Jan and I believe it still has room to run on the downside.
Now, interestingly, just this week Gross cited another "short of the century", calling for a top on Chinese Internet Stocks in the near term. But with another 25 IPOs coming down the pipeline this one will face a lot of headwinds. Man, I heart summer volatility...
http://www.bloomberg.com/news/articles/2015-06-03/gross-s-ne...
The article doesn't mention, and acknowledges this, whether treasuries or corporate bonds are worrying people. If the former it could be back to 'normal interest rates' (or at least ones that reflect and account for economic growth), if the latter then another recession, but I think this call is 3 years too early.
The article talks about CDOs and CDSs - the book 'The Big Short' by Michael Lewis is a good read about CDOs and CDSs in the run-up to the 2007/2008 crash.
But isn't all this rhetoric and fear mongering just here to promote a continuation of the zero interest rate policy? Japan's been there for 20 years and we're only at year 8...we've got to maintain zirp forever now. The list of terrible things that will happen in a rising rates environment is quite long.
For them, it's the equivalent of having people buy and sell an index of classic cars. If there is a big sell-off then you can't really expect to get a great price on selling all these classic cars when they might normally be bought or sold a few times a month. Being a forced seller is never good....
The economy is a balance sheet, however simplified or complexified it may be made. A low return on capital represents a low growth of capital. In some economies with less transparent capital markets, the link to official interest rates and actual growth is difficult at best, but in more developed capital markets the cost of capital is well proxied by the interest rate. And if the interest rate is low, the return on capital (at a macro level, totaling and summasing the micro level anecdote - micro level opinions go both ways) is low, and if that is low, then growth is low.
Extra: Bond price falls indicate a move into risk. This is especially good for people affected by stock price falls coupled with low interest rates - 401kers for example, approaching retirement age with money in growth. Interest rates (higher) make buying annuities a lot more attractive.
For example: Gov'ts issue bonds on a regular basis to finance their debts. They depend on that market being there in order to continue normal operations. If liquidity evaporates, then many participants will not partake in the auctions, which is A Big Problem. Likely a central bank (a "lender of last resort") will step in for that case, but that only emphasizes that there are big market problems to the participants.