Das: Volatility is warning

Via Bloomie comes Satyajit Das:

But the unusual size of the moves — regularly on the order of 1 per cent to 3 per cent — is being heightened by something else: the struggle to find someone with whom to trade.

The decline in trading liquidity is evident in several metrics. Volumes have declined. Since 2007, average daily trading in US Treasury bonds (measured as a percentage of market size) has fallen by over 60 per cent.

…Other telling indications include significant intra-day moves, frequent price spikes, higher volatility of bid-offer spreads and the proliferation of flash crashes such as the sharp increase in the Cboe Volatility Index or VIX at the end of 2018 and the Japanese yen flash in January 2019.

…The problem, as traders are rediscovering, is finding a chair when the music stops. Investors are underestimating and under-pricing the risks diminished market liquidity could pose in the next downturn.

Duetsche recently warned of similar:

 Finance shifting to non-banks. Recent events* have been a timely reminder of the potential risks of illiquid securities within open-ended mutual funds offering daily liquidity. According to the FSB (Financial Stability Board), over half of global intermediation now happens outside the banking system. The assets of NBFIs (Non-bank financial Institutions) have grown by over 50% since 2008.

 Have liquidity risks shifted? While post-crisis banking regulations have materially reduced liquidity (& other) risks within the banking system, we believe some of these risks could have been transferred to the NBFI ecosystem, notably mutual funds.

 Mutual funds have geared into corporate bonds. US corporate bond outstandings have doubled since 2005 with recent issuance running at $1.5trn pa (Slide 5). Over the same period, mutual funds’ ownership of corporate bonds has increased from 12% to almost 30%, or c$2.6trn (Slide 6); the balance is largely held by insurance and pension funds 45%.

 Is liquidity an illusion? By contrast, dealers inventory of corporate bonds has declined by c90%. Thus, the ratio of corporate bonds held by mutual funds vs dealer inventory has increased from 2x in 2007 to 43x currently. In short, the buy-side significantly outweighs the sell-side and the gap has never been bigger. This comes at a time when BBB represents c60% of the Investment Grade and c250-300% of the High Yield market.

 DB ‘canary in the coal mine’ indicator: The DB Distress ratio** has typically been a strong lead indicator into a credit default cycle by c9 months. In turns, a break over 10% had typically been followed by strong double-digit banks’ underperformance. Please do not hesitate to ask us for the relative importance of corporate bond funds for US asset managers or if you would like to receive regular updates of the DB Distress ratio.

This is why I worry about oil as a trigger for a broader end of cycle shock. The last spike in junk distress was driven by the 2015 oil crash channeling global contagion into US debt markets via shalers.

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