Hypothetical ‘$2 Trillion Disasters’ And What Not…

The term “liquidity” is the gift that just keeps on giving when it comes to providing fodder for scary-sounding stories about the inherent fragility of modern market microstructure.

To be sure, liquidity is a problem, and that means anyone who wants to pen something about it is justified in sounding the alarm. It’s just a matter of whether a given article does a good job of homing in on which aspect of the problem the author is looking to address – this a multi-faceted debate and the term “liquidity” is inherently amorphous/nebulous, so one has to be clear on what it is that’s being discussed.

Is it “bottom-up” liquidity, wherein an acute lack of market depth conspires with systematic flows to exacerbate drawdowns and drive up volatility during selloffs? Is it “top-down” liquidity, where that means liquidity provision by central banks who, until last year anyway, were keen to keep the wheels greased and underwrite carry trades with credible forward guidance? Is it what Jamie Dimon called “macro liquidity” in his latest annual letter, where that’s a combination of top-down liquidity and broader financial conditions? Or are we talking about “liquidity” in the context of some specific concern like, for instance, the possibility that the mismatch between outstanding corporate debt and the street’s capacity to warehouse risk in an onerous post-crisis regulatory environment will one day cause problems (see chart below)?

(Deutsche Bank)

A Bloomberg article dated Friday called “Hidden Bond Market Dangers Expose Traders to $2 Trillion Wipeout” (how’s that for over-the-top hyperbole?) zooms in on the latter point mentioned above and, by extension, touches on the discrepancy illustrated in the visual from Deutsche.

This is another one of those times where I suppose I need to temper my sarcasm to account for the fact that media outlets thrive on engaging stories and in many cases “engaging” ends up being synonymous with “hyperbolic”. That said, the opening line is all kinds of silly. To wit:

Behind the rally in global debt markets lurks a disaster just waiting to happen. 

Oh, ok. So I guess let’s just pack it up and prepare to live out Cormac McCarthy’s The Road, then. To be fair, Bloomberg does soften the blow by ascribing that dire pseudo-prediction to “some long-time market watchers.”

The whole article is based on the idea that when you think about this year’s rally in fixed income in the context of the above-mentioned liquidity mismatch, you come away worried that the combination of everything being priced to perfection (thanks to the potent one-two punch of dovish forward guidance and the hunt for yield catalyzed by the surge in negative-yielding debt) and the structural liquidity mismatch which has arguably become a fixture of the market, could end up creating a perfect storm.

So, where does the “$2 trillion” figure from the headline come from? Well, as you might imagine, that’s just duration risk. “Currently, the duration of $52 trillion of investment-grade bonds globally stands at about 7, close to a record high”, Bloomberg goes on to write, before noting that “if yields rose a half-percentage point [the bonds would lose] 3.5% of their market value, or a $1.8 trillion loss.” Here’s a chart:

Again, this is just the same story recycled. Central banks worked on both the supply and the demand side of the equation post crisis. Artificially suppressed borrowing costs encouraged debt issuance (with the proceeds in some cases plowed into buybacks), while rock-bottom/negative rates created voracious demand for anything that promised any semblance of yield.

2019’s “everything” rally in fixed income and the concurrent surge in the global pile of negative-yielding debt (which topped $10 trillion again late last month amid the ferocious DM bond rally) brought the issue back to the fore.

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When Bond Markets ‘Go Mad’

As noted on Saturday, this year has seen junk spreads tighten dramatically off the Q4 wides and investors seem to have completely forgotten about the “BBB apocalypse”/”fallen angel doomsday” narrative. BBBs have returned nearly 6% so far this year. Q1 was the best first quarter for BBBs since 1995. Here’s a snapshot for some context within IG:

And this is just a kind of 30,000-foot view of the best quarter for global bonds since 2017:

Finally, here’s a look at flows:

(BofAML, EPFR)

The gist of all this – in case it isn’t clear enough – is that dovish central banks have again stepped in to theoretically reduce default risk and prolong the cycle, while forward guidance on rates and lackluster global growth have pushed DM bond yields into the floor, thereby turbocharging the hunt for yield. Investors jittery about the viability/sustainability of the equity surge appear to have no such worries about fixed income given the laundry list of favorable technicals.

And so, we’re all left to ponder what might happen should the global love affair with bonds suddenly sour, leading to a scenario where large outflows need to be funded and the street isn’t able/willing to warehouse the risk.

Meanwhile, any sign that the nascent “cyclical reflation” story that’s gotten legs over the past two weeks is set to be sustainable (e.g., if we were to get concrete news with regard to more Chinese stimulus and/or something definitive on a shift in the Fed’s inflation framework), could well push bond yields higher, exposing some of the “hidden risk” Bloomberg flags.

Take all of that for what it’s worth, and do note that waiting around on some of the risks mentioned above to actually play out and manifest themselves in something dramatic has been a fool’s errand for years.