[NEW YORK] Federal Reserve governor Jerome Powell voiced concerns Wednesday about illiquidity in the fixed-income markets, saying no one knows how to address a problem that could take years to solve.
"Fixed income markets around the world are much less liquid than they were," Powell said at the Council of Foreign Relations in New York. "There are not a lot of obvious answers on what we are supposed to do," he said. "It is something I suspect we will be thinking a lot about and spending a lot of time on for some years." Liquidity is sharply down since the financial crisis, and the fear is that the bond markets could grind to a halt if a rise in rates sends retail investors rushing for the exits.
Before the crisis, US investment banks and other dealers held almost US$250 billion of fixed-income risk assets, like corporate bonds and structured securities, on their balance sheets.
In part, this allowed them to have enough bond inventory to quickly meet the buying and selling requirements of investors, while also letting them make bond bets of their own.
But new post-crisis regulation makes it too expensive to hold large inventories and outlaws proprietary trading in which banks buy and sell bonds purely to make a profit for themselves.
The result is that dealers are neither in possession of enough bonds to make a fully liquid market, nor willing to step in themselves - as they did in the past - when conditions are volatile.
Dealer inventories of fixed income risk assets, including structured products, have dropped by about 80 per cent since the crisis, according to Federal Reserve data.
That's left the bulk of outstanding bonds in the hands of the biggest asset managers, such as retail mutual funds.
The concern is that when rates rise, retail investors could panic and race to get out, which could force the funds to all be selling at once in order to meet redemptions.
And with a rate rise seen coming from the Federal Reserve this year, worries about a bond market meltdown have grown steadily more intense. "The first time the Fed raises rates, whether it's 25bp or 50bp, there will be a lot of money that will want to get out of fixed income - and who is going to be on the other side of that trade?" said Stephen Gallagher, the US head of Algomi, which makes software to speed transactions between buyers and sellers. "In the past, traders on the sell-side provided a cushion to the market by stepping in and making markets," Gallagher said. "Now it will go into freefall - and instead of taking days to find equilibrium, it could take weeks."
Severe dislocation after the Fed raises rates is taken as a given - in part because the central bank has kept rates so low for so long.
Both the International Monetary Fund and the Bank of International Settlements have warned of late about a looming crunch that could see the bond market dry up quickly. "Recent bouts of volatility remind us that liquidity can evaporate quickly in financial markets," the BIS said in a recent report.
For many, the crucial question now is how long the disruption will last.
Some believe it will be short-lived and relatively benign, largely because a rate rise would signal an improving economy - and thus better credit fundamentals for corporate bonds.
Managers of pension fund and insurance company money would be expected to wade back in to the market and make the most of the soaring yields on bonds as retail investors panic and sell.
Many sophisticated portfolio managers have strategies in place to increase exposure to bonds when they hit rock-bottom prices. "There is no doubt in anyone's mind that the market is very illiquid and that will be a problem when the Fed starts raising rates," said Oleg Melentyev, head of credit strategy in the Americas for Deutsche Bank. "But that said, we are not going to suffer an Armageddon-style meltdown that leads to systemic risk. Institutional investors will be there to come in, and many portfolio managers are set up to profit from illiquidity and forced sales." Melentyev said he took comfort from how often key figures like Powell had been sounding the alarm. "It means they are taking this market problem into account when they consider monetary policy," he said.
Algomi's Gallagher said: "If the Fed signals to the market that its first hike will not be repeated for a certain period of time, then things will stabilize. But if the Fed indicates it is the first of many in a period of six months or a year, then the disruption will last a lot longer."