“The first lesson [about liquidity] is that the relative significance of the factors that determine liquidity under normal conditions and under stress can differ substantially.”

– Bank for International Settlements (Claudio Borio)(1)

In my recent posts on liquidity in the bond markets, and especially in the riskier sectors such as junk bonds and bank loans, we’ve noted that major figures in the financial industry are warning that bond market liquidity is dangerously low. We’ve looked at the facts – the huge boom in junk bond issuance and the collapse in the size of bond dealer inventories – and found that they do, indeed, seem to be alarming on their face. But we also reviewed a careful study indicating that, while liquidity in the junk bond markets wasn’t terrific, investors were being well-compensated for bearing it.

But for most of us the real question isn’t about how liquidity is behaving in a normal market environment, but about how liquidity is likely to behave in a stressful environment. Mostly, we have to speculate about this, but there are a couple of ways we might vector in on a conclusion. For example, there have been a few post-Financial Crisis events that bear looking at and that might be instructive:

The “taper tantrum.” In May of 2013, then Fed chair Ben Bernanke remarked that, at some point, the Fed’s QE program would have to slow down, that bond buying would have to taper off. This was like remarking that, at some point, the sun will come up. But the markets freaked. Between Bernanke’s remarks in May and mid-September, the yield on the 10-year U.S. Treasury gained 140 basis points and the price of the bonds dropped almost 4%. In the Treasury bond market, those are big moves.

The “flash crash.” On October 15, 2014 Treasury yields dropped 40 basis points in one day. Talk about a big move! According to Jamie Dimon, CEO of JP Morgan, that move was “statistically [a] 7 to 8 standard deviation [event] – an unprecedented move – an event that is supposed to happen only once in every 3 billion years or so.” What seems to have happened is that the day launched with heavy trading by investors betting on an improving economy. But that morning a small tsunami of negative economic data was released and Treasury yields plummeted.(2) Trading activity was staggering, surpassing even the heavy volume observed following the collapse of Lehman Brothers.

The recent volatility in European sovereign bonds. Earlier this year yields on even longer term European sovereign bonds turned negative, an exceptionally rare event. Investors buying such bonds and holding them ‘til maturity were guaranteed to lose money, but the bonds were in great demand anyway. This was The Greater Fool Theory in action: because of the ECB’s huge QE program, traders believed yields would go even lower and the bonds could be sold at a profit.(3) In fact, in late April yields rose and the wrong people turned out to be fools. When yields are very low to begin with, seemingly small changes in yield can send prices tumbling. By early May, yields on German bunds were six times higher than they’d been in mid-April, with correspondingly large losses of principal.

Anecdotal reports. We’ve heard reports that some credit-oriented hedge funds have experienced serious difficulty liquidating positions to meet unexpected redemptions. By “serious difficulty,” I mean the inability to sell the position at anything remotely like its most recent marks.

What, if anything, can we learn from these events? Not much, I’m afraid, but maybe two things:

(1) First, while bond markets are certainly skittish, they aren’t ominously fragile. The taper tantrum was over in a few months and mainly offered nimble investors an opportunity to profit from oversold markets. The “flash crash” happened so quickly you’d have missed it if you’d gone to the kitchen for coffee: yields fell from 2.19% to 1.86% and back to 2.13% in mere minutes. And while it’s too soon to know the final outcome of the excitement in the Euro bond market, it seems likely that few people got hurt other than speculators in negative-yield debt.

(2) Probably more important for most investors, stressed bond markets didn’t seem to transmit their viruses to the rest of the market.

That last point is crucial, because what we’re talking about here is, what about the rest of us? Suppose we don’t even own any junk bonds, having had the good sense to dump them – along with our bank loans – some time ago. Why should we care about investors who are gorging on junk bond yields that are lower than they could have gotten on a bank savings account a few years ago?

The answer is “financial contagion.” People who didn’t own mortgage bonds, people who didn’t even have mortgages, still got badly hurt in 2007 – 2008. By focusing on how contagion works, we can zero in on what it is that could happen in the bond markets that should worry investors in general, not just investors in junk bonds.

What is financial contagion? A good definition is this one: “Contagion is best defined as a significant increase in cross-market linkages after a shock to an individual [market sector] (or group of [sectors]), as measured by the degree to which asset prices … move together across markets relative to this co-movement in tranquil times.”(4)

In other words, junk bonds melt down and suddenly the stock market collapses. But why? How does contagion work? It can operate via several different channels. Here are a few examples:

Investor expectations. If junk blows up, investors might suppose that all risk assets are in trouble. This could be a perfectly rational thought or maybe it’s lunacy, but it’s a self-fulfilling idea. Everybody rushes for the exits at once, just as in a run on a bank.

Game theory. I may know perfectly well that the junk market is blowing up for reasons that have specifically to do with conditions in Exotic Bond Land. But I also know that most investors – and especially most retail investors, who own gigantic chunks of junk bond mutual funds – don’t know this and are likely to panic at the first sign of serious trouble. Not wanting to be the guy who has to turn out the lights, I sell immediately.

Actual linkages. Suppose that a great many junk bond investors have bought on margin. When the margin calls come, these investors start selling whatever they can sell that isn’t safe (i.e., not a US Treasury). Selling pressure hits the stock markets, where even more people have bought on margin. It gets ugly quick.

VaR linkages. Banks, investment banks, mutual fund companies, large institutional investors and others monitor the risk levels in their portfolios constantly. When the value at risk numbers get too high, these folks don’t just sell junk bonds, even though that’s where the action is, they sell risk assets generally.

How do we know whether frightening events in the bond markets are leading to nothing more than Schadenfreude for junk bond owners or might be leading to Armageddon? My best guess is that the real meltdown will come only when something substantive, not merely tantrum-inducing, happens. Here, for example, is a future day in the life of a non-junk-bond investor:

* 9 a.m.: you arrive at your desk just in time to catch the Bloomberg story about Britain and Greece announcing – on the same day – that they will leave the Eurozone.(5)

* While you are digesting this news – literally, at lunch – you check the widescreen monitor over the bar and notice that the Fed has surprised the markets by raising rates much higher than anyone expected. Doc Yellen lamely explains that, “We waited too long, so now we have to make up for lost time.”

* Because you are a long-term investor, you force yourself not to call your broker. You tell yourself that Britain, Greece, Yellen, it’s all already in the price. But on your longish commute home, listening to reruns of Car Talk on NPR, the program is interrupted by this bulletin: China has announced that, as part of its anti-corruption campaign, it has discovered that capitalist running dogs in its economic statistics department have been overstating China’s GDP growth rate for years. True current GDP growth is closer to 4% than to 7%. Aggregate GDP figures will be revised downward, says the bulletin, by 30% to 40%.

It no longer matters that liquidity is more-or-less okay under normal conditions – conditions have suddenly stopped being normal. It no longer matters how contagion happens – that’s something for the history books to mull over. It no longer matters that extortionate prices of risk assets can easily be justified by historically low interest rates or by slow-but-not-recessionary GDP growth. No, everyone is suddenly riveted by alarming Shiller P/Es, by even more alarming P/E-to-GDP ratios, and by a preposterous bubble in household net worth that puts 4Q07 to shame. On top of all this, it has suddenly become very clear that, because the Fed holds so many safe bonds on its balance sheet via QE, there aren’t enough Treasuries to meet the demand, resulting in panic-feeding-upon-panic.

By the time you arrive home, it’s too late to sell, but you don’t mind because, having been a loyal reader of a certain investment blog which modesty prevents us from naming, you were already well-positioned for this madness.

(1) Market Liquidity and Stress: Selected Issues and Policy Implications, BIS Quarterly Review, November 2000.

(2) I don’t know about you, but it seems a bit odd to me that when the value of your bond suddenly goes up, people refer to it as a “crash.”

(3) See my series of posts titled “On NIRP,” beginning 4/2/15.

(4) Dornbusch, Park and Claessens, Contagion: Understanding How It Spreads, The World Bank Research Observer, vol. 15, no. 2 (August 2000). This article is primarily about financial contagion from country to country, rather than from market sector to market sector. Hence the brackets in the quote.

(5) What happens when a market gets too high? A Brexit-Grexit corrects it.

 

Next up: Slow Recovery or Secular Stagnation?

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.