Central Banks Warn: Liquidity May Evaporate When Investors Finally Remove Blindfolds

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Companies are selling bonds like madmen. This year through Tuesday, investment-grade and junk-rated companies have sold $438 billion in new bonds, up 14% from the prior record for this time of the year, set in 2013, according to Dealogic. This quarter is already in second place, nudging up against the all-time quarterly record of $455 billion of Q2 2014.

About $87 billion of these bonds funded takeovers, a record for this time of the year, the Wall Street Journal reported. The four biggest bond sales in that batch were for healthcare takeovers, including the Actavis deal whose $21 billion bond sale was the second largest in history, behind Verizon’s $49 billion bond sale in 2013.

Actavis had received orders for more than four times the bonds available, according to CFO Tessa Hilado. “You don’t really know what the demand is until people start placing their orders,” she said. “I would say we were pleasantly surprised.”

Brandon Swensen, co-head of U.S. fixed income at RBC Global Asset Management, couldn’t “see anything on the radar that’s going to slow things down materially,” he told the Wall Street Journal. His firm expects rates to “remain low.”

All of the investors chasing after these bonds expect rates to remain low. Or else they wouldn’t chase after these bonds. If rates rise, as the Fed is promising in its convoluted cacophonous manner, these bonds that asset managers are devouring at super-high prices and minuscule yields are going to be bad deals. And their bond funds are going to take a bath.

But companies are selling bonds as if there were no tomorrow. They’re thinking that rates will not remain low. They’re trying to get these things out the door cheaply while they still can. They’re on a feverish mission to take advantage of these ludicrously low rates while they’re still available. And they use this cheap money to buy each other and to repurchase their own shares to pump up share prices and max out executive compensation packages, rather than investing it in productive activities.

So is the Fed giving split signals?

Corporate issuers interpret these signals to mean that this won’t last, that they need to sell as much cheap debt as possible before rates rise, perhaps sharply. But bond fund managers interpret these signals in their own way, lulling themselves into thinking that rates will stay low forever.

One side is misreading the Fed’s signals. Perhaps bond fund managers don’t care; all they have to do is be as good as the market. And when rates go up, the entire market takes a beating, and bond fund managers individually can hide behind that.

But what happens when investors in these bond funds figure out that their bond fund managers had taken the wrong side of the bet, that corporate issuers had known all along what bond buyers had closed their eyes to – rising rates falling bond prices – and now they’re trying to unload their bond funds?

When bond funds face these kinds of redemptions, they first plow through their cash, then they try to sell the more liquid bonds in their fund, such as Treasuries, and if that isn’t enough, the less liquid bonds.

But liquidity is a funny thing: it evaporates without notice, just when you need it the most.

Liquidity gives you the ability to sell something without having to slash the price. When no one wants to sell and when you don’t need liquidity, there’s plenty of it. But when you really need liquidity to sell something because you see something worrisome, then everybody else sees the same thing, and they too need to sell. Buyers, who also see the same thing, disappear. And liquidity just evaporates.

It doesn’t mean you can’t sell. It means you have to slash your price to sell. Everyone has to slash their prices in order to lure buyers out of hiding. And worse, as prices get slashed in a highly leveraged market, margin calls go out, hedge funds get nervous, and leverage begets forced selling. And prices drop further. But this leverage once provided liquidity, and now it doesn’t go anywhere else and doesn’t shift to other assets, but gets paid off. It too just evaporates.

That’s the dynamic of market mayhem.

After six years of global QE and interest rate repression, absurdly inflated valuations – from government bonds with negative yields to junk bonds with ultra-low yields – have become the norm. But liquidity has become, to use the Bank of England’s expression, “more fragile.”

Last week, the Bank for International Settlements rang the alarm bells on liquidity, fretting that bond markets have become vulnerable to these sorts of shocks. And yesterday, the Bank of England Financial Policy Committee released the statement of its March 24 meeting that was jam-packed with warnings about “market liquidity risks” – and potential “sharp adjustments in financial markets.”

It cited the Treasury flash crash last October as an example of when liquidity even in the supposedly most liquid of bond markets – US Treasuries – just evaporated. As it said, “sudden changes in market conditions can occur in response to modest news.”

And it frets: “investment allocations and pricing of some securities may presume that asset sales can be performed in an environment of continuous market liquidity, although liquidity in some markets may have become more fragile.”

Not that central-bank warnings have any impact on investors. They’re too busy chasing yield. And thus government bond yields continue to bounce along near zero, or below zero. High-grade corporate bond yields are so small they’re barely discernible. Junk-bond yields show that there are few risks out there, even for the riskiest companies in the riskiest sectors. It has taken central banks six years to blindfold investors to risk, and now investors have become addicted to these blindfolds and simply don’t want to take them off. But when they do, possibly all at the same time, they’ll find out that the liquidity they thought would be there for them has just evaporated.

In the American heartland, real businesses are already getting nervous. “We don’t see the economy being as strong as portrayed in the national media,” the Kansas City Fed quoted one of them. Read…  You Should See the Reasons Cited for the Plunge of the Kansas City Fed Manufacturing Index

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  10 comments for “Central Banks Warn: Liquidity May Evaporate When Investors Finally Remove Blindfolds

  1. Phil Collins
    Mar 27, 2015 at 12:16 pm

    The bond bubble will explode this year. All the signs are there

    • NotSoSure
      Mar 27, 2015 at 1:38 pm

      I don’t know Phil, this party can go on forever. CB frets about liquidity but they can always flush the system with more money like what they’ve been doing. The only thing that’s for sure is that we may never see a normal bond market again in our lifetime.

      • Gil Obrero
        Mar 28, 2015 at 7:34 am

        No, the party cannot go on forever.
        If you are thinking in a linear way, then it may seem the obvious and simpleness solution,. Print a trillion a year every year , year in and year out for almost ever.

        It doesn’t work that way, mathematically it cannot happen, because as time goes by and all other3 fact4ors come together, the linear model starts to rapidly break down and there is simply not enough cash at even a trillion a year to satisfy redemption and coupons with the yield start to rise at an ever accelerating rate.

        To counteract that tendency you have to increase the amount of liquidity you have in the system at an ever escalating rate and there is a point on the somewhat hyperbolic shaped curve whereby the steepness of the curve cannot be reduced,
        That is a specific point based on the precise shape of the curve where it becomes the point of no return.

        The acceleration on the curve is too great now, an no amount of reverse application can slow it sufficiently to decelerate it.
        On a linear model the acceleration is constant, and that’s how people intuitively think, but reality is never so simple.

        like getting too close to a black hole. or too close to bankruptcy. it might seem just as safe an inch closer, but in fact its already over, and the realization comes when you think you can apply the brakes and suddenly find they simply don’t work anymore. and the accelerator has jammed.

        And the funny think is that only one needs to hit the brake pedal and find it doesn’t work, and at that moment everyone’s brakes fail.

        • mick
          Mar 28, 2015 at 9:14 am

          Well said Gil. I’m both grateful and frustrated to have a front row seat to the greatest debt bubble in history, combined with the greatest delusion in history.

          I don’t need to work out the math, because I know that if printing money endlessly worked, we would’ve done it by now. I guess the temptation is to think that there’s a way to print just the right amount each hear, ever increasing, but not allowing inflation to get out of hand.

          Nice fantasy, but not reality.

  2. michael
    Mar 27, 2015 at 10:35 pm

    The beauty of mathematics is that there is a single correct answer. If the FED could do QE forever they would have. This, like all bubbles will end. It only seems like forever when you are watching.

  3. Jungle Jim
    Mar 28, 2015 at 12:35 am

    Back in the aftermath of the Lehman collapse (it seems so long ago) Alan Greenspan was testifying in front of a House of Representatives Committee examining the financial mess.

    Rep. Barney Frank (in a disbelieving tone), “Didn’t anyone see this coming?”

    Alan Greenspan “Oh, lots of people said it wouldn’t work, of course we didn’t believe them.”

    Nothing has changed. If you are dealing with people who have a vested interest in not recognizing truth when they see it, you will be repeatedly “taken by surprise” when the ship hits the sand.

  4. Julian the Apostate
    Mar 28, 2015 at 1:35 am

    The bond investors and the passengers on the Germanwings flight share a flawed premise: that the pilot’s goal is to carry them safely to their destination. What if it’s not?

    • mick
      Mar 28, 2015 at 9:24 am

      Since the FED’s inception, the % of booms and busts has increased dramatically, yet for some strange reason, investors think the FED’S mandate is stability. I know they say it is, but their track record says otherwise.

      The FED will crash this market like they have crashed many others before. Why? Because the FED is owned by the big banks, which profit as much or more in a planned crash than they do in a boom. Of course, knowing the exact timing, nature, and scope of the crash sure does make the process much easier.

      • NotSoSure
        Mar 28, 2015 at 7:12 pm

        The FED’s not exactly a bureau of humanitarianism, but this reeks of conspiracy theory too much. If the big banks knew about the exact timing, they wouldn’t have to be bailed out in the first place would they? And instead of a Lehman moment, we’ll just have a Fascist takeover, and right now we’ll be hailing each other.

  5. rjohnson
    Mar 28, 2015 at 9:03 pm

    The bid-ask spreads should widen as liquidity vanishes. This should give you plenty of time to get out. :)

    As long as bonds can be rolled over using cheap money the party will continue.

    If the markets blow up due to rate rises the FED will be obligated to start the whole party all over again. I would guess this is the scenario most are positioning themselves for.

    Blowing up the world is a great trading opportunity.

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