Macro Commentary

Every asset is liquid at a price, or so they say.  In the financial world, liquidity is typically defined as the ability to trade in a security without impacting its price.  It has often been discussed that the bond market has suffered from declining liquidity, especially since the financial crisis.  While the trading floors of the New York Stock Exchange (and others) have long seen the horde of traders replaced with computers electronically matching bids and offers, the bond market remains dealer driven.  That is to say, while there is growth in the use electronic trading in fixed income, most trades are still executed between a customer and a dealer via phone or Bloomberg terminal.  Then comes the global financial crisis which resulted in two colliding phenomena.  First, with prolonged low interest rates both government and corporate issuers rushed to market increasing the amount of debt outstanding.  Second, as banks sought to de-lever their balance sheets, bond dealers had to shrink their inventory and thus the limit the amount of trading they can do at any one point in time.  Sure, as capital flowed strongly into fixed income as confidence in equities was low post-2008, it did not appear much of a concern.  But now that we are reaching a turning point, the question of liquidity in the bond market becomes especially relevant.

A look at numbers put together by Deutsche Bank suggests that the area for biggest concern might surprise people – government bonds.  According to their analysis of the US bond markets, the amount of US Treasuries trading on any given day over the trailing 12 months as a percent of issuance outstanding has fallen 70% compared to down 30% for high yield and 50% for investment grade bonds.  Granted, Treasuries still trade the most between the three and there is a “denominator” effect (the US government issued the most of all) but it is impactful.  Take into consideration, the significant increase in sovereign yields globally just this week.  Looking at the government 10yr maturity in each country, Japan increased 10bps, the UK increased 27bps, the US increased 28bps, and Germany increased 34 bps.  That is a correlated and swift move up in yields in a range of countries that have independent and diverging central bank policies and economic/inflation conditions.  The implications could be wide sweeping, from financial stability (sovereign debt is common collateral for repo arrangements that banks use to fund themselves) to economic (rising capital costs affect investment) to financial (increasing discount rates mean that all future cash flows are considered worth less today).  Thinking ahead of investor sentiment, what happens when the investor’s thirst for yield (fund flows into bonds) turns into fear over falling price (fund flows out)?  At this point, our guess is bad for bonds and equities as it happens but better for equities in the intermediate-term as the beneficiary of fund flows looking for both yield and growth.  Needless to say, we are keeping a close watch.

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