Don't Confuse Bond Market Liquidity with Volatility

The last few weeks have been quite tough for the developed market bond and currency markets.

Volatility is up dramatically. Bunds have traded up and down five points in the course of a few hours and cash treasuries have moved around 10-15 basis points a day. The carnage in the European government bond markets has been especially noticeable given that the ECB’s quantitative easing announcement is only a few months old and is likely to be in place until the fall of 2016. Moreover, secular rather than cyclical pressures are likely to keep European rates low for an even longer period than U.S. rates.

As a result, the blogosphere has now become focused on what it believes is a lack of liquidity in the fixed income markets. To back up their case, bloggers point to the large intraday price moves and to the fact that dealer inventories of all things fixed income are lower than before the crisis.

As you have probably guessed from the title of this note, I have a huge problem with that. What they’re calling bond market illiquidity is really bond market volatility.

First of all, dealers don’t make a market liquid, investors do. Dealers are simply facilitators. In other words, if the price of a bond is going down by several points for a fundamental or technical reason, it’s unrealistic to expect a dealer would step in and slow down that fall. The only thing that would smooth the bond’s descent would be the actions of other investors who have a materially different viewpoint on the direction of that security. Either they anticipated the move and were positioned for it, or they had the capital necessary to express a different viewpoint.

Therefore, any problems we may have in the bond market won’t be solved by higher dealer inventories or lower capital requirements. No dealer is going to take the other side of the trade if they don’t foresee another investor with a different viewpoint becoming a buyer somewhere down the road. It would be just too much risk for them to warehouse.

Take bunds, for example. If an investor wants to sell bunds, there are plenty of dealers willing to buy them. But at this point, risk premiums for bunds are very low and there isn’t much diversity of opinion in the market. As a result, dealers are only willing to buy them at a certain price—and sellers don’t like the prices they’re being offered.

The real problem isn’t the illiquidity of the bond market—it’s the volatility of bond prices. Most bond investors have the same viewpoint and risk premiums are low. The consistency of viewpoints has been driven by central bank policies—and those policies have been specifically designed to support global deleveraging after a multi-decade build-up in leverage.

If you accept this premise, the next question to ask is what might cause this volatility to become a pervasive problem for the fixed income markets on a global basis.

I believe that volatility will become a problem for the markets when investors have had enough of bonds. That point won’t come when the Fed raises rates. It will come when the process of global deleveraging ends. That deleveraging process won’t end because folks save more. One person’s saving is someone else’s debt, so high savings actually raise the total stock of debt. The deleveraging process will only end in one of two scenarios. It will end when the underlying nominal economic growth rates become higher than the growth rate of the total stock of debt (or savings, the flip side of debt). Or it will end when debts are written down in a big way. For the developed markets, neither is likely any time soon.

In conclusion, the recent big moves in bunds or treasuries don’t foretell a breakdown of the fixed income market. Instead, they are telling us that too many investors are on the same side of the boat. In other words, risk premiums have become too low and need to be rebuilt in a hurry. All the talk of dealer inventory and liquidity mumbo jumbo is just a distraction.

Some pundits would have you fear that even a modest Fed rate hike will cause catastrophic dislocations in the fixed income markets. I disagree. We can expect real disruptions in the bond market when the secular deleveraging process ends—but we still have a decade or two to go

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