Regular readers know credit market liquidity is a favorite topic of ours.
As more than a few folks have noted, the combination of central bank largesse and the proliferation of HFTs has likely had a deleterious effect on liquidity across markets. Of course those two developments (the dawn of the NIRP/ZIRP/QE era and the rise of the machines) have progressed in tandem and therefore, it’s reasonable to assume that all else equal, markets are far less liquid than they once were. Throw in the post-crisis regulatory regime that’s made banks more cautious about lending their balance sheet and you’ve got a recipe for illiquid markets.
That said, “liquidity” is an amorphous concept. What exactly is it? Is it bid-asks? Is it the ability to transact in size? Or, perhaps most importantly, is it the ability to get the fuck out of dodge when one needs to?
Well, BofAML is out with a sweeping update on credit market liquidity and although the details are interesting, we’re going to go out on a limb and say they’ll make for better weekend reading than they will something folks are willing to wade into on a day dominated by nuclear war headlines.
That said, one easily digestible bit from the note focuses on central bank QE and its effect on liquidity and markets. This is another hotly debated issue, but you’ll note that one thing which isn’t up for debate is the extent to which policymakers are dramatically decreasing the supply of available securities.
Of course that’s a two-way street. Because when policymakers pull back, a dearth of securities created by insatiable demand from price insensitive buyers will morph into a surplus of securities that will have to be absorbed by price sensitive investors. The implications of that should be clear.
Read more below and do note Chart 2, which shows the magically shrinking free-float in the FI market…
The CSPP has dominated the European credit market over the past year. The ECB now owns more than €100bn of euro-denominated corporate debt (and growing) more than a year since it bought the first corporate bond under CSPP. CSPP has been pivotal improving the credit market’s strength and resilience. The most recent example is the striking outperformance of credit against other risk assets. For instance equities are struggling to advance, while credit spreads are moving tighter.
Away from credit the ECB also owns more than 25% of the bund market. The BoJ remains one of the top shareholders across a plethora of local companies. Also, the Fed still has more than $4.4tr of assets, despite discussing balance sheet reduction.
It appears the central banks’ asset buying programs have stabilised markets and suppressed volatility to record low levels. Amid a growing stock of assets owned by the central banks on a global scale, the free float of available assets has declined and thus volatility has subsided significantly. Both realised and implied vol across asset classes is now close to record low levels.
On the liquidity front, however, the picture is not clear. Even though absolute bid/offer costs have declined, we could say that this is predominantly a result of broadly tighter spreads. We note that bid/offer costs per unit of spread have not improved in line with the speed of spread tightening. Albeit turnover stats have declined in the IG euro and sterling markets, stats have improved somewhat in the HY space. Even though trading volumes have not mirrored the market size expansion in the past four years, there is a notable improvement over the 12 months.
Lower supply + CSPP = fewer bonds available for traditional credit investors We think that the ECB has been pivotal in reducing market risk uncertainty, containing sell-offs and increasing investors’ confidence on valuations. With tighter spreads, absolute bid/offer trading costs have compressed. However, as the ECB (predominantly) and the BoE have been buying corporate bonds in the past year, the free float in the market has reduced.
I guess the question one is left with goes something like this: what exactly are we doing, as a society (so that includes governments and corporations across developed economies), when we simply print money to buy debt we just issued from ourselves?