Get Used to Selloffs, Central Bankers Say as They Fret about the Terrifying Moment When Liquidity Evaporates

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Axel Weber, president of the Bundesbank and member of the ECB’s Governing Council until he quit both in 2011 to protest the ECB’s bond purchases, quickly landed a new gig: chairman of UBS. WHIRR went the revolving door. From this perch, he warned in 2012 that the easy-money policies and the expansion of central-bank balance sheets would lead to “new turmoil in the financial markets.” Now that the turmoil has arrived, he’s at it again.

“Volatility and repricing” – a euphemism for losses – are “part of getting back to normal,” he told NBC. We should get used to it, he said, echoing what ECB President Mario Draghi had said a couple of days ago. So no big deal. However, he was fretting “about the liquidity in the market, in particular under stress situations.”

Despite unleashing a deafening round of QE on the European markets, the ECB has watched helplessly as government bonds have done the opposite of what they should have done: Prices have plunged, and yields have spiked. The German 10-year yield soared in seven weeks from 0.05% to over 1% on Thursday, before settling down a bit. And it wasn’t even a “stress situation.”

US Treasuries have sold off sharply as well since the beginning of February, with the 10-year yield jumping from 1.65% to 2.31%, the worst selloff since the taper tantrum in 2013.

Now one word is on the official panic list: “liquidity.” They’re thinking about the terrifying moment when it suddenly evaporates.

Weber blamed central banks for the liquidity issues in the global bond markets. They’ve been buying “vast amounts of assets and putting them on their balance sheets”; not just government bonds but also corporate bonds. Since central banks “buy and hold,” they “take some liquidity out of the market.”

He pointed at regulation that “has moved a lot of banks out of market-making into more long-term sustainable business models,” he said. UBS, for example, has turned from investment banking to wealth management.

And the Fed’s forward guidance has changed from a nearly unified statement about not raising rates to a cacophony on whether to raise rates earlier or later. “That actually impacts pricing in the market; market moves are then translated into much bigger moves because people aren’t on the same page.”

Everyone is chiming in with their fears that liquidity in the bond market will dry up just when you need it the most.

The liquidity that investors believed they had in the bond markets was “illusory” during the last crisis, explained Fed Governor Daniel Tarullo at an Institute for International Finance summit on Thursday. Like Draghi, Weber, and many others, he said that investors should get used to more volatility. It’s liquidity they’re worried about.

So in effect, get used to selloffs. It’s all part of “re-pricing,” as Weber had put it so eloquently. It’s the new normal. IF there is enough liquidity, “re-pricing” is going to be orderly. But that’s a big IF.

The next crisis will “probably be oriented to lack of liquidity,” BlackRock CEO Larry Fink said at the same summit. And there’s “the potential for frozen markets….”

That’s when everyone panics.

But the bond rout might have another cause, one that has been assiduously denied all around: Inflation expectation (as measured by the difference in yield between 10-year Treasuries and 10-year Treasury Inflation Protected Securities) is 1.8%. On a 10-year investment, it’s logical that investors would want to beat inflation by a smidgen.

Some markets are by nature illiquid. The housing market, for example. When you put a home on the market in normal times, you might get an acceptable offer after a couple of months. If the market turns sour, you might not be able to sell it at all at a price you can live with. Or you might have to drop the price by 30%. That’s lack of liquidity.

At the rarefied air where properties sell for tens of millions of dollars, it can take years to unload a property. The California mansion used in Scarface came on the market in May 2014 at $34 million. Recently, the price was dropped to $17.8 million. Lack of liquidity. In the housing market, it’s expected.

Homes, classic cars, art, farmland, a factory… they’re all more or less illiquid assets. Everyone knows it, and so it’s no big deal. Until there’s a bust, and then suddenly it’s a big deal.

Bond markets are supposed to be fairly liquid, with the US Treasury market being the most liquid. Corporate bonds are less liquid. Each bond issue is different, and even in good times, it may take days to find a buyer for a particular bond at a price that won’t kill the seller. But when liquidity dries up – that is, when buyers with liquidity lose interest – these bond markets can seize, and that’s when forced selling leads to a collapse in prices, runs on bond funds, panic, and mayhem.

Even conservative sounding “open end” bond funds can get eviscerated when they experience a run and are forced to sell their holdings into an illiquid market [Are These Ticking Time Bombs in Your Portfolio?].

Stock markets are very liquid, supposedly. Trading is electronic, accomplished in microseconds, with prices disseminated globally in real time. Manipulation runs rampant, and you get screwed, but you can always assume that there is going to be someone at the other end willing to buy the crap you’re trying to dump. Until there isn’t.

One day during the crash of the dotcom bubble, I received a friendly margin call from my broker and became one of the forced sellers. I tried to unload my trash first. One of the stocks was a former dotcom highflyer. I’d bought it at a beaten-down price a few months earlier, trying to catch a falling knife. So when I tried to sell it, there were no buyers willing to pay more than a few cents. Liquidity had evaporated before my very eyes, just when I needed it the most. Even in the stock market.

But liquidity magically reappears when the price is low enough. For central bankers who’ve been inflating asset prices for years, and for investors who’ve gotten fat and lazy from these policies, that simple fact is a terrifying thing.

The EU’s top regulator for insurers and pension funds wasn’t kidding when it warned that QE was triggering treacherous “volatility” in the bond markets. “Volatility” isn’t actually the right word. It implies ups and downs. But euro sovereign bonds have experienced a brutal rout. Read…  ECB Loses Its Grip, Bond Market Comes Unglued

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  8 comments for “Get Used to Selloffs, Central Bankers Say as They Fret about the Terrifying Moment When Liquidity Evaporates

  1. HD
    Jun 5, 2015 at 7:30 am

    Quantitative Easing referring to creating digital money to provide liquidity aka the modern form of money printing. When a CEO tells us the environment is “challenging”, this means in all likelihood his company will go bust. And then there’s this little gem, in this very article: “repricing” now stands for the concept of losses.

    We declare, explain, photoshop, like/unlike, reprice our way out of reality these days. We have become a global society of liars and deceivers, the world has become one gigantic PR operation: it is not important what actually happened, it is important to determine how we are going to sell whatever it is that actually happened to the public in such a way that they don’t panic. Heck, we should even try to deceive ourselves, so that we don’t panic either and will still be able to sleep tight at night.

    I’m telling you guys (and girls): the awakening is going to be one for the history books. We’re in urgent need of a decent mirror. If we can’t be honest with ourselves, sooner or later it will be inflicted upon us.

  2. Julian the Apostate
    Jun 5, 2015 at 7:58 am

    Daddy Wolf, tell us again about the panic and mayhem; it’s my favorite part! (Just kidding) I too, in a much more benign exprience ran into the illiquidity wall, when my “friendly” Citicards bankster jacked my rate to 19.9% (which I expected) then a month later to 32.99% which I most certainly did not. I deactivated the cards and froze them, one is now gone and the other WILL BE in less than 2 years. And now they send an avalanche of credit card offers that I just ignore. I’m sure they can’t figure me out, but hope springs eternal. Regards,
    JULIAN

    • Petunia
      Jun 5, 2015 at 1:32 pm

      When I lost my house it ruined my credit. Department store cards I had for decades, with zero balances, got pulled by the stores. Those stores could use my business now but they won’t get it. I vote with my feet and my money.

    • a Texas libertarian
      Jun 5, 2015 at 1:33 pm

      Julian,

      Ouch man. Luckily I was not into my credit cards for very much for the housing crash, and I was too young to be in any trouble for the tech crash. This time around, however, I’ve got some credit card debt that I’m desperately trying to pay off, because I think high interest rates are just around the corner. I think we have maybe six months to a year left in the current cycle. Who knows though? With bond yields creeping up around the world, despite all the central bank infusions of credit, however, it seems an end to the madness is near.

      • CrazyCooter
        Jun 5, 2015 at 2:10 pm

        Do understand the difference between secured debt and unsecured debt. Usually credit card debt is unsecured (know your laws/rules/regs) and if you don’t pay it, they can’t really do anything other than threaten. If the debt is secured, you might lose the asset associated with the debt (e.g. car) or you might be liable in court (e.g. a judgement against you that has to be paid unless you can BK).

        Good call paying off your stuff (and stay there once you are out of debt), but if you have other debts (e.g. car) be mindful you have your priorities straight if something bad happens like a job loss.

        You can sleep in your car (or sell it) … if it is paid off and you have title.

        I have a HELOC, a credit card, and an auto loan left to deal with. I bias towards paying off my auto loan first for the reason stated above. I float the other two until I have title.

        Regards,

        Cooter

  3. Vespa P200E
    Jun 5, 2015 at 9:09 am

    Volume and certainly volatility proceeds price movements and the 6 yr old bond/equity markets may be in for reality check.

    Oh yeah the margein debt is at record and soon the little and big investors will soon learn that liquidity dries up instantly and get the dreaded margin calls.

  4. Julian the Apostate
    Jun 5, 2015 at 7:41 pm

    Roger that, Cooter. Fortunately we own our house outright, and my old work car that we bought new in 2001. Was debt free in ’06 but had a real bad streak of luck that put us back in debt. I just put new timing and drive belts on the old beast ($538) but the alternative of replacing it would be a great deal more than that, so I plan to drive it til the wheels are the size of walnuts. The 2012 that the wife drives will be paid for in 2.5 years, at 6%. Working on a pay-as-you-go basis these days.

  5. mick
    Jun 7, 2015 at 12:41 pm

    “Getting back to normal” isn’t possible any longer. Maybe back in 2010, with lots and lots of pain, but not now.

    Rising rates will destroy the markets and economy, since that’s all that supports them at this point.

Comments are closed.