December 26, 2016
Not long ago I had dinner in my hometown of Darien, Connecticut, with one of the best sources on the inner workings of the U.S. Treasury bond market. Our dinner took place at the Ten Twenty Post bistro, the same restaurant I wrote about in my first book, Currency Wars.
It was there that a friend and I invented the scenario involving a Russian and Chinese gold-backed currency that we played out in the Pentagon-sponsored financial war game described in that book.
Now I had returned for another private conversation with another friend. But this time we were not discussing fictional scenarios for a war game. The conversation involved real threats to real markets happening in real-time.
I can’t reveal the identity of my dinner companion, but suffice it to say he is a senior official of one of the largest banks in the world and has over 30 years’ experience on the front lines of bond markets.
He has been a regular participant in the work of the Treasury Borrowing Advisory Committee, a private group that meets behind closed doors with Federal Reserve and U.S. Treasury officials to discuss supply and demand in the market for Treasury securities and to plan upcoming auctions to make sure markets are not taken by surprise.
He’s an insider’s insider who speaks regularly with major bond buyers in China, Japan and the big U.S. funds like PIMCO and BlackRock. For purposes of this article, let’s just call him “Mr. Bond.”
Over white wine and oysters, I told Mr. Bond about my view of systemic risk in global capital markets. In effect, I was using Bond as a reality check on my own analysis.
First, you must develop a thesis with the best information available. Then test the thesis against new information every chance you get. You’ll soon know if you’re on the right track or need to revise your thinking. My conversation with Mr. Bond was the perfect chance to update my thesis.
I told Bond that markets appeared to be in a highly paradoxical situation. On the one hand, I had never seen so much liquidity.
Literally trillions of dollars of cash had been sloshing around the world banking system in the form of excess reserves on deposit at central banks — the result of massive money printing since 2008.
On the other hand, something was definitely wrong with liquidity. The Oct. 15, 2014, “flash crash” of rates in the Treasury bond market was a case in point.
On that day, the yield on the 10-year U.S. Treasury note fell 0.34% in a matter of minutes. This is a market in which a change of 0.05% in a single day is considered a big move.
The Oct. 15 flash crash was the second most volatile day in over 50 years. Something was strange when there was massive liquidity in cash and complete illiquidity in notes at the same time.
Yields crashed from 2.2% to 1.86% between 7:00 a.m. and 9:45 a.m., with most of that crash taking place in just a few minutes between 9:30 and 9:45, just after the stock market opened.
Almost no one alive today in the bond market had ever seen anything like this.
I told Mr. Bond that this Treasury market flash crash looked a lot like the stock market flash crash of May 6, 2010, when the Dow Jones industrial average index fell 1,000 points, about 9%, in a matter of minutes, only to bounce back by the end of the day.
This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses.
It was important to me to move beyond the theoretical and see whether an active market participant like Mr. Bond agreed. His answer sent a chill down my spine.
He said, “Jim, it’s worse than you know.”
Mr. Bond continued, saying, “Liquidity in many issues is almost nonexistent. We used to be able to move $50 million for a customer in a matter of minutes. Now it can take us days or weeks, depending on the type of securities involved.”
According to Mr. Bond, there were many reasons for this. New Basel III bank capital requirements made it too expensive for banks to hold certain inventories of securities on their books.
The Volcker Rule under Dodd-Frank prohibited certain proprietary trading that was an important adjunct to customer market making and provided some profits to make the customer risks worthwhile.
Fed and Treasury bank examiners were looking critically at highly leveraged positions in repurchase agreements that are customarily used to finance bond inventories.
Taken together, these regulatory changes meant that banks were no longer willing to step up and make two-way customer markets as dealers. Instead, they acted as agents and tried to match buyers and sellers without taking any risk themselves.
This is a much slower and more difficult process and one than can break down completely in times of market distress.
In addition, new automated trading algorithms, similar to the high-frequency trading techniques used in stock markets, were now common in bond markets. This could add to liquidity in normal times, but the liquidity would disappear instantly in times of market stress.
The liquidity was really an illusion, because it would not be there when you needed it. The illusion was quite dangerous to the extent that customers leveraged their own positions in reliance on the illusion. If the customers all wanted to get out of positions at once, there would be no way to do it and markets would go straight down.
Another factor that Mr. Bond and I discussed over dinner was the shortage of high-quality collateral for swap and other derivatives transactions.
This was the flip side of money printing by the Fed. When the Fed prints money, the do it by purchasing bonds in the market and crediting the seller with money that comes out of thin air.
This puts money into the system, but it takes the bonds out of circulation. But banks need the bonds to support collateralized transactions in the swap markets.
With so many bonds stuck inside the Fed, there was now a scarcity of good collateral to go around in other markets. This was another type of illiquidity that left markets on the knife-edge of collapse.
As Mr. Bond and I finished our meal and polished off the last of wine, we agreed on a few key points.
Markets are subject to instant bouts of illiquidity despite the outward appearance of being liquid. There would be more flash crashes, probably worse that the ones in 2010 and 2014.
Eventually, there would be a flash crash that would not bounce back and would be the beginning of a global contagion and financial panic worse than what the world went through in 2008.
This panic might not happen tomorrow, but it could. The solution for investors is to have some assets outside the traditional markets and outside the banking system.These assets could be physical gold, silver, land, fine art, private equity or other assets that don’t rely on traditional stock and bond markets for their valuation.
Original Article: Business Insider – A bond market insider explains why the market is illiquid
