Afternoon Must-Read: Gillian Tett: In Parched Bond Markets, Sparks Are Dangerous
In Parched Bond Markets, Sparks Are Dangerous:
“According to the governor of the Bank of England…
…it now takes seven times as long for investors to liquidate bond portfolios as in 2008. The reason? Eight years ago investment banks and brokers held such large inventories of bonds and other assets that they were happy to act as market makers…. The ‘exits’ for trades, to use banking jargon, are crowded. And that means that while the markets might seem placid today, particularly given the easing announced by the Japanese and European central banks, this calm could come to a halt if investors try to sell en masse. ‘Fundamentally, liquidity has become more scarce,’ Mr Carney says….
The big question is what will happen when the US Federal Reserve starts raising rates. If investors rush to sell US government bonds, that will create one seriously crowded exit…. Is there a solution? Behind the scenes, there is plenty of brainstorming. For now regulators seem opposed to the step bankers most want: a relaxation of reforms such as the international Basel III regulations or America’s Dodd-Frank act….
Ever since the days of Walter Bagehot, the 19th century British economist, central banks have accepted that one of their roles is to lend freely to solvent institutions in a crisis. But they have generally shied away from acting as market makers or from rescuing non-banks. ‘Backstopping market liquidity directly risks structurally distorting economic incentives,’ the BIS paper notes. But the 2008 crisis and its aftermath have forced central banks to break many taboos. If a bond crisis erupts, this one may crumble too, forcing central banks to jump in. As Mr Carney observed in Singapore: ‘Bagehot will need to be updated for the 21st century.’ Watch this policy space, and that sevenfold statistic.
Central banks “have generally shied away from acting as market makers or from rescuing non-banks”? If you are holding duration risk or entrepreneurial risk during the financial crisis, You are a bank. That is what banks do: they undertake liquidity, entrepreneurial, and duration transformations. You can call yourself a rubber duck if you want to and an attempt to engage in regulatory arbitrage. But you are a bank. And in the event of a financial crisis your life or death is the central bank’s business. For central banks to pretend that there are “non-banks” that perform liquidity, entrepreneurial, and duration transformations is for them to adopt the ostrich nature.
And “shied away from acting as market makers”? Bagehot’s Rule: in a financial crisis, lend freely at a penalty rate on collateral that would be good in normal times. If that isn’t being a market maker, then I am Marie of Roumania. It is being a market maker in exceptional times when nobody else is willing to be–when everyone else thinks that the likelihood that current traders know something is more of a risk to market makers than the close and intimate connection with order flow they get by being market makers is a gain. But it is being a market maker.
And “the big question is what will happen when the US Federal Reserve starts raising rates. If investors rush to sell US government bonds, that will create one seriously crowded exit…” Only if the Federal Reserve wishes it so. The Federal Reserve can pick any point on the yield curve it wishes, and absolutely nail that point. Whether it can nail other points depends on the credibility and implementation of its communications strategy. But it can nail one point. And if it is seriously worried about the risk that the long Treasury bond will collapse in value when it starts raising short-term safe interest rates, it can direct the New York Fed’s trading desk to target not the Federal Funds rate but the Ten-Year Treasury bond rate. And it can always back that up with interest on reserves.
Very few people in high finance seem to understand how powerful a central bank that prints an ultimate reserve asset for the world economy–that possesses exorbitant privilege–is. Only if it lets itself get backed into a corner in which it has pledged itself to defend against depreciation a currency value that the market does not believe in can it get into serious trouble, and the only reason the Federal Reserve would do that is if it feared as a shepherd that its major sheep had been very naughty and had done too much currency transformation as well.