Monday, June 8, 2015

The Looming Liquidity Crisis

A recent piece by Nouriel Roubini on the Project Syndicate website gives us a strong hint of a looming crisis in the world's markets.  While some of you may have heard of Mr. Roubini, here is a bit of background for those of you that haven't.

Dr. Nouriel Roubini is a professor of economics at New York University Stern School of Business.  He served as a senior economist for international affairs on the White House Council of Economic Advisors.  Dr. Roubini is renowned for his September 7, 2006 speech before a crowd of economists at the International Monetary Fund where he warned that the United States was likely to face a housing crash and a deep recession as shown in this excerpt:

"I argue that housing today, like the tech bust in 2000-2001 will have a macro effect; it is not going to be just a sectoral effect. I argue that U.S. consumers are now close to a ‘tipping over’ point given all the vulnerabilities I have discussed. I argue that the Fed easing will occur, so the next move is going to be a cut, but it is not going to prevent a recession. And, finally, I argue that the rest of the world is not going to be able to decouple from the U.S. even if it is not going to experience an outright recession like the United States. So on that cheerful note, I will stop."

In his latest missive, Dr. Robin discusses the emerging liquidity paradox that has appeared in the economy since the Federal Reserve and other central banks have been using unconventional monetary policies to solve the world's economic ills since 2008.  These policies have pushed up the size of the monetary base as shown on this chart:

At $3.951 trillion, the monetary base is now 467 percent larger than it was just as the Great Recession took hold at the end of 2007.   This means that the U.S. economy is flush with liquidity, thanks to the Federal Reserve's "printing presses".  All of this money has ended up lifting asset prices, including bonds of both the private and public sector, stocks and housing among others.  Asset prices, in some cases, are now decoupled from realistic valuations, particularly in the bond market where some bonds are now trading with negative (or near zero) yields.

Dr. Roubini goes on to note the two relatively recent bond market "hiccoughs", the first of which is shown on this chart:

As soon as Ben Bernanke telegraphed that the Fed would begin to taper its purchases of long-term securities in the spring of 2013, interest rates shot up by nearly 100 basis points in a very short period of time.  This event is known as the "Taper Tantrum".  In fact, as shown on this graphic, the main part of the Taper Tantrum took place over a very, very short period of time:

Again, on October 15, 2014, U.S. Treasury yields plunged by 34 basis points (7 to 8 standard deviations) in a matter of minutes, an event that should have occurred only once in three billion years according to statisticians.  According to Nanex, liquidity evaporated in Treasury futures, prices skyrocketed and yields plunged.  Here is a quote from Wall Street on Parade:

 "One of the key concerns floating around Wall Street is that the Federal Reserve itself may be a source of liquidity stresses in the Treasury market place. As a result of its previous, massive Quantitative Easing (QE) programs, it’s sitting with $2.4 trillion in Treasury securities on its balance sheet as of its report dated April 2, 2015. Keeping that supply out of the marketplace is part of the Fed’s monetary policy strategy to keep interest rates low and boost economic activity. However, in times of stress when trillion dollar banks and billion dollar hedge funds want to instantly flip out of junk bond ETFs, stocks and other riskier assets and into the safe haven of U.S. Treasuries, there may not be enough supply to go around given the trillions of dollars in high risk assets that now dominate the globe."

Dr. Roubini observes that one of the differences between the world's equity and fixed income markets is that bonds of all types are not traded on exchanges that are as liquid as stock exchanges.  Most bond trades take place over-the-counter in markets that are relatively illiquid.  Many of these bonds are held in funds that allow investors to divest of their positions at any time.  This means that banks which offer these funds containing these illiquid bond assets may be forced to sell at a moment's notice (i.e. on demand); the need to sell the illiquid assets into an illiquid market could push prices down very, very quickly.  In other words, there is a significant liquidity mismatch in the Treasury market that could cost fixed income investors dearly.  The events of both the spring of 2013 and October 15, 2014 give us a sense of just how painful that lesson could be to investors.

Dr Roubini concludes with the following:

"This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into overvalued, increasingly illiquid assets – such as bonds – the risk of a long-term crash increases.

This is the paradoxical result of the policy response to the financial crisis. Macro liquidity is feeding booms and bubbles; but market illiquidity will eventually trigger a bust and collapse." (my bold)

The liquidity mismatch issue is yet another unintended consequence of the Federal Reserve's six year experiment with a series of unproven monetary policies.  This one could prove to be just as painful to investors as the stock market readjustment in 2008 - 2009.

1 comment:

  1. The value of bonds is based on long-term predictions of government deficits and inflation.These forecast are often formed using assumptions based on rosy scenarios and politically skewed to benefit those in power. Like many investors I think the bond market is a bubble ready to pop and won't touch bonds with a ten foot pole. Knowing what we know about the effect that interest rates have on the value of bonds one might deduce that the 30 year bull run on bonds will have to come to an end the moment rates are expected to go up.

    To give you a sense of what this may mean to U.S. Treasury Bond investors a 10 year treasury bond issued at a 2.82% interest rate could see a 42% loss in value from a mere 3% rise in interest rates. This means if you hold $100,000 in these bonds after this 3% increase in rates, you would only be able to sell those bonds for $58,000 in the secondary market. Not only would bond holders be stripped of wealth if rates rise or even worse soar, but the higher rates would magnify the nations debt service and rapidly impact our deficit in a negative way. The article below explores just how big a problem this path could cause.