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Changes in market structure drive bond market volatility

IN our recent conversations with fixed income traders and portfolio managers, we have detected a heightened sense of unease, driven by uncertainty about the economic and financial market outlook. On the one hand, domestic demand is sound in most parts of the world, despite a rise in energy prices and tightening liquidity conditions. On the other hand, financial markets look fatigued in some places and downright stressed in many emerging market economies. Additionally, while the trade war may be dominating the headlines, it is increasingly seen as a China-US matter.

Causing more stress is the rising US rate policy and tightening of liquidity. In our conversations with regulators and market participants in recent days, we have picked up a common refrain. Recent sharp sell-offs of government bonds in Argentina, Italy and Indonesia have all taken place with strikingly little volume. The large price movement has nevertheless left many asset managers with bond portfolios with considerable mark-to-market losses, which means that even if they see emerging value in some bonds, they will not be in a position to bid for them.

This bodes ill for the countries that need to come to the market for fresh issuance in the coming months. The search for yield may not have diminished, but the ability to take on risk has, which will probably push up market clearing yields considerably.

Why are we in this situation? Well, it is largely a legacy of the 2008 global financial crisis. Led by the US, but followed fervently by Europe, regulations have led to an increase in bank capital buffers (definitely a good thing), reduced risk appetite (with good and not-so-good effects), and reduced trading volume (again, good and bad). Banks, traditionally the market makers through their proprietary trading desks, have largely stopped pursuing such activities. When a bond buyer comes to the market, banks seldom buy those securities to warehouse them. Instead they strive to pass on the risk to another buyer, whose availability and appetite can be highly variable.

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This is a key reason why bid-ask spreads have steadily widened in recent years, culminating in a major widening lately as market stress has risen. With banks no longer playing an active role in the middle and liquidity declining, investment firms have become a bigger holder of risk, without seeing a commensurate rise in returns.

Since no regulatory changes are in the pipeline to alleviate this dynamic, we can expect more volatility and higher cost of funding in the coming year. The matter is further complicated by the fact that many countries have large financing and refinancing needs next year due to rising energy prices (which affects the current account) and a sharp increase in borrowing (hence, ballooning short-term debt on a residual maturity basis) in recent years.

Related to this development is the rapid growth of the non-bank financial sector in the past decade. As banks have de-risked, risk has migrated to the balance sheets of fund managers and brought in numerous non-banks into the business of lending.

We have two areas of concern. First, private equity companies, funded by foreign capital, have become involved in lending in large projects in emerging markets. These loans have FX mismatch embedded in them; ongoing sell-off in EMFX makes them more onerous to service. Second, non-bank financial companies, with the help of fledgling financial technology, have been extending an array of loans to households and SMEs, ranging from auto financing to mortgages. The next wave of defaults could well come from this area, as rates rise.

There is a troubling gap in supervision in this context. Most central banks focus on bank supervision directly, while they monitor non-banks only in the framework of overall financial stability assessment. Indeed, given the light touch regulatory application on the non-bank financial sector, the question is if there is a degree of regulatory arbitrage driving its expansion while reducing the regulator's visibility of risk buildup. From a surveillance perspective, central banks tend to track bank credit growth, but at a time of fast expansion of non-banks, the metric has begun to lose its value. A glaring case in point is India, where in 2017 most financial system credit was generated in the non-bank financial sector (bond issuance and NBFC lending), with its beleaguered banks accounting for just 48 per cent.

Financial crises occur with regularity simply because regulation tends to fight the latest crisis, while risk migrates somewhere else. Since the GFC, banks have become undoubtedly safer, but that has not mitigated the risk of an asset price boom-bust cycle. Over the past decade, we have seen household debt surge in the US, corporate debt jump in China, and borrowings in emerging markets spike. As rates rise and debt service distress mounts, the balance sheet of the non-bank financial sector may well be the canary in the coal mine - an inadvertent result of the post-crisis regulatory environment.

  • The writer is chief economist of DBS Bank.