Markets Are Sick. QT Is Dead

“Signs of sickness are growing in markets,” Nomura’s Charlie McElligott said Tuesday.

It was a generalized assessment, but McElligott was prompted by the Bank of England’s latest bond market intervention, which found Andrew Bailey stepping into linkers citing “the prospect of self-reinforcing ‘fire sale’ dynamics” and the associated “material risk to UK financial stability.”

I should emphasize that if central banks are publicly talking about “self-reinforcing ‘fire sale’ dynamics,” it must be pretty bad. Notwithstanding officials’ penchant for stumbling into “own goals” (Steve Mnuchin “US banks have plenty of liquidity”-style), policymakers typically try to avoid using terms like “fire sale” in news releases.

Read more: Linker Madness Forces Bank Of England Further Down Rabbit Hole

The BoE story was (unfortunately) lost in the proverbial shuffle Tuesday, despite being arguably the most important market narrative on the board. McElligott called the ongoing drama in UK fixed income “the headliner.”

In a lengthy statement, the UK’s Pensions and Lifetime Savings Association underlined the anomalous character of recent price action. “The historically high speed of repricing and market moves were unprecedented,” the industry group said, adding that “in some cases, even prudent risk management practices or regulatory stress tests were insufficient to manage the resulting volatility.” The PLSA went on to describe “rapid and spiraling collateral calls” for defined benefit funds using LDI strategies.

Market participants should understand that the UK pension crisis and associated BoE emergency response aren’t idiosyncratic episodes. Yes, there are idiosyncrasies specific to the UK LDI complex, but more generally, these are the withdrawal symptoms of addicted markets. And they’re going to get worse. QT will become increasingly untenable going forward. It’s just that simple. Markets can’t take it.

On the heels of the R** discussion and an October 8 Nick Timiraos article called “Fed’s Inflation Fight Has Some Economists Fearing an Unnecessarily Deep Downturn,” Fed officials began to reference financial markets and allude to long and variable lags in public speaking engagements. Lael Brainard on Monday said the Fed “recognize[s] that liquidity is a little fragile in core markets and so we’re carefully monitoring conditions.” On Tuesday, Loretta Mester was characteristically hawkish in remarks to Bloomberg, and said balance sheet runoff should continue as planned, but she too mentioned market functioning and said the Fed is “monitoring” the situation. Expect to hear (much) more of that going forward. A Timiraos article dated October 10 carried the title, “Two Fed Officials Make Case for Caution With Future Interest Rate Raises.”

Bailey on Tuesday insisted the BoE will end bond-buying as planned on Friday, despite the PLSA’s warning that “the period of purchasing should not be ended too soon.” “Many feel it should be extended to the next fiscal event on October 31 and possibly beyond,” the group said. Bailey put on his brave face and played bad cop. “My message to the funds involved and all the firms is you’ve got three days left now,” he chided, speaking at the Institute of International Finance annual meeting in Washington. “You’ve got to get this done.”

We’ll see how long that sort of bluster lasts in the face of what may very well be another selloff next week, “and possibly beyond,” to channel the PLSA. The idea of the BoE unwinding its purchases or starting QT on schedule later this month remains wholly laughable. Bailey is setting himself up for a humbling experience. His Tuesday remarks sparked an adverse reaction across markets.

“This is all looking increasingly panicky into the upcoming (purported) October 14th completion of the BoE’s ‘temporary’ bond-buying program,” McElligott wrote. “At this juncture, it feels increasingly likely that these ‘targeted’ purchase operations are at risk of eventually being expanded indefinitely, as the doom loop of margin calls dictates ongoing fire sales that are spilling over into all liquid assets.”

Writing late last week, Goldman’s Praveen Korapaty was direct. “Market fragility could constrain central bank QT,” he wrote, calling market microstructure “exceptionally weak, with top-of-book market depth in bond futures contracts across geographies being close to the worst levels of the past five years.”

BNY Mellon’s John Velis echoed that sentiment. “Liquidity in the bond market is deteriorating” and is worse than pre-pandemic averages across the world’s largest sovereign bond markets, he said this week, on the way to noting that although we’re “well aways from a serious hiccup in the world’s most important market, when thinking about what could induce a pivot in Fed’s tightening policy, at the moment the risks of plumbing issues are rising.”

In the same noted cited above, Goldman’s Korapaty cautioned that the “poor supply of liquidity means realized volatility will likely remain high, and indeed feed on itself [as] high delivered volatility leads to further reduction in the supply of liquidity.” He continued:

We have previously noted that sovereign debt market microstructure started to erode even before QT began in many regions, largely because of the loss of a large backstop buyer. The deterioration in the market’s ability to easily transfer risk has led to larger-than-average daily swings (even after controlling for the macro environment), and periods with big flow imbalances like that seen in March 2020 with US Treasurys and in the last few weeks with gilts can produce some of the largest intraday swings on record. We believe central banks will show limited tolerance for impaired sovereign debt market functioning. Indeed, both the Fed’s large-scale purchases back in March/April 2020 and the BoE’s recent intervention were primarily to restore orderly functioning, and highlight the potential for microstructure issues to short-circuit a central bank’s QT plans.

Again, there’s a growing consensus (or, if that’s too strong, we can call it a shared supposition) that QT isn’t going to be viable much longer, unless developed market central banks intend to countenance illiquidity and impaired functioning in their respective sovereign bond markets. I’ve said it time and again over the last several months: Market functioning in DM government bonds will take precedence over the inflation fight every, single time.

In his daily, Rabobank’s Michael Every wrote about gilts, the BoE and the above-mentioned remarks from Bailey. “In other words, restructure the entire industry by Friday by selling whatever is needed,” Every said, summarizing Bailey, and calling that message “outright dangerous.”

It “clearly makes gilts a target,” Every went on to say. “Time-limited central bank backstops never work,” he added, noting that Mario Draghi’s famous line most assuredly wasn’t “Whatever it takes… until Friday.”