Liquidity shifts and moves
admin | August 9, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
When markets trade with the kind of volatility seen in August, asset liquidity not only changes but moves, too. The implementation of the Volcker Rule in 2014 raised the stakes for bank broker-dealers thinking about taking customer flows into inventory. And bank broker-dealers consequently have become less inclined to buffer flows, especially in products where it might take time to find the next buyer or lay off risk. Independent broker-dealers, however, are another story.
Volcker’s reporting requirements and penalties for transactions that might look proprietary have reduced the willingness of bank broker-dealers to commit capital to positions that could linger on the balance sheet, according to a recent study of trading in corporate bonds from 2006 to 2016. Independent broker-dealers, not bound by Volcker, have increased market share in corporate trading since 2014, raised the proportion of flows done in block trades and increased capital commitment to balance sheet positions. The differences between bank and independent broker-dealer balance sheets have been most pronounced in stressed markets when liquidity typically drops.
Although the study focused on corporate bonds, the results arguably hold for any market or market segment where positions trade infrequently. In those markets, a broker-dealer runs the risk of getting caught in positions for a long time or showing spikes in daily trading profits. Volcker requires broker-dealers to report inventory turnover and the volatility of daily trading profits. Low turnover or volatile P&L could get flagged as possible proprietary trading subject to penalties from regulators and risk to broker-dealer reputation.
For independents, Volcker has opened a door. Independents’ share of corporate bond trading rose from 4.4% of total volume before the 2008 financial crisis to 13.5% in the initial years of Volcker. And the share of that trading where the independent committed capital as principal instead of acting as agent rose from 76.2% pre-crisis to 90.9% after Volcker—all while bank broker-dealers’ tendency to act as principal stayed flat from pre-crisis to Volcker at between 92% to 94%.
The implication for investors in any infrequently traded asset is that liquidity over time both rises and falls and shifts between bank and independent broker-dealers. The willingness of broker-dealers to take positions into inventory and work out of them over time buffers the market from the impact of outsized trading flows. In small issues or small market sectors, even modest flows can move spreads if a broker-dealer lacks time or incentive to search for the best bid. That’s an especially important consideration for a portfolio selling only a portion of its total position in a given name or sector where any retained exposure gets marked to the new spread.
The market volatility implied in the swaptions market has jumped this month to some of the highest levels of the last three years, suggesting a fair amount of uncertainty about the direction of rates and the value of fixed income assets. If the volatility gets realized, liquidity will likely vary significantly. Every portfolio would be well advised to think about liquidity strategies now before markets potentially force the issue.
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The view in rates
The realized day-to-day and intra-day interest rate volatility of the last week reflects justifiable market skittishness about trade and monetary policy. The direction of trade policy is hard to predict, other than that the conflict between the US and China looks set to run deep into next year. Monetary policy seems lashed to the mast of trade. Monetary policy should dampen the impact of trade but may not be able to completely offset it. Interest rate volatility, at least reflected in the MOVE index, has jumped to the highest levels in three years. Convexity should perform well deep into 2020.
Rates have dropped and the yield curve has flattened dramatically in August. Rates on the front end of the curve are limited by a Fed unwilling to commit to aggressive easing yet, but rates in the long end continue to signal concern about growth and inflation. If trade tensions keep rising, rates in the long end could fall further and further flatten the curve.
The view in spreads
Investors in spread products have to be able to ride out the likely higher spread volatility ahead for the balance of the year. It still seems likely the Fed will help buffer the impact of trade policy, but that is not certain. If the US pushes tariffs on an incremental $300 billion in Chinese imports to 25% and China counters with currency devaluation, both economies could weaken and concerns about recession rise. Spreads would have widen to compensate. If that unfolds, buy on the widening and wait for the Fed to counter.
The view in credit
As Stephen Stanley pointed out recently, the recent benchmark GDP revisions raised estimates of household income by $400 billion and made the household balance sheet look even stronger than before. Low interest rates have spurred mortgage refinancing, which should further reduce household debt burden. Low rates should also give some support to home prices, which should help homeowners continue building their equity. Of the major balance sheets in the economy—government, corporations, households and banking—households clearly are the strongest.