The Liquidity Monopoly
I’ve been racking my brain to think about the bond market, and all that it implies. I think Treasury securities are a bubble, but that’s a very different sort of bubble than we are accustomed to. Most bubbles involve risky assets, and are driven by greed. This bubble involves “safe” assets, and is driven by fear.
During fear, market players seek liquidity. Liquidity means many things, but in this case it means the ability to reverse direction at low cost, and fast. Nothing feels truly safe, aside from the most trusted entities in the market, maybe. Governments, with their taxation authority, assume leading roles, and low funding costs. Those allied with the governments get low funding costs as well, and everyone else has to suffer.
This is particularly evident now, because of the wide spreads between Treasuries, Investment Grade Corporates, and High Yield Corporates. Trading volumes are tilted to higher quality securities — Treasuries, Agencies, and those that they guarantee. Even the Fed expressing willingness to buy Agencies or long Treasuries can produce a real rally in the short run.
Whether well-intentioned or ill-intentioned, the government’s efforts to support areas of the market draw liquidity away from unsupported areas of the market, helping lead to wide credit spreads in the unsupported areas. Personally, I don’t think it is a help overall; by making a sharp distinction between areas that the government will protect, and those it won’t, it increases the total panic level — better they should not guarantee anything. Their own life is at enough risk already.
What we are seeing is a liquidity monopoly. The government, by misguidedly trying to assure liquidity in markets that are under stress, end up replacing the markets as they intervene, and hoard liquidity to themselves. The result is a lack of liquidity outside of their favored areas.
You’ve heard me say before: bubbles are financing phenomena. They end when cash flows to finance the bubble are inadequate to carry the assets in the bubble. But wait — we’re talking about Treasury securities here. How does this work, because it’s not as if there are a ton of leveraged players here, right?
Well, no. We do have the T-bill market, and the short stuff is close to zero, or negative. The repo market implies negative rates on Treasury collateral, though not always.
What is more clear is that an increase in price inflation, or greater currency depreciation would leave a sour taste in the mouths of buyers of Treasury securities. Real returns would go negative. It hasn’t happened yet, but the great temptation will eventually be to monetize the new debts that our government cannot afford to pay back.
In closing, some articles:
- Start with the eminent James Grant, who no one is laughing at any more. With Treasuries, we no longer have risk-free return, we have return-free risk. (Also, Henry Blodget at Clusterstock.)
- This is not just a US phenomenon — it is happening to long government rates in many developed nations.
- We have the Fed buying short Agency notes. (And Bloomberg.)
The government may think that it is aiding market liquidity, but by providing guarantees, it is absorbing liquidity, and starving the markets that it does not guarantee. Thanks for nothing, you are doing more harm than good.
December 6th, 200811:51 am at
You are definitely on to something interesting here, but I think you need to clarify what exactly the “fear” is of? Is it risk of default, or is is that the risk of lack liquidity itself? I raise this because of the extreme behavior in the TIPS market. There is no risk of default on these bonds — – they are treasuries, unlike FDIC guaranteed or “implicit” guaranteed debt such as Fannie or Freddie, which bear some risk greater than that of Treasuries, however slight. The only risk to the coupon is deflation — – but does the remote possibility of sustained deflation explain more than a tiny fraction of what’s been going on with them? I don’t think so. The obvious problem with TIPS is liquidity, or lack thereof. This suggests to me that the overwhelming explanation for the poor performance lately of TIPS, and perhaps other nearly risk-free bonds — – general obligation municipal bonds in particular — – is lack of liquidity. And who would be most concerned about lack of liquidity? I would think it would be highly leveraged players like hedge funds, who simply can’t afford to be stuck with any illiquidity in a panicky market. I’d be interested in your thoughts about this. And, if the problem is lack of liquidity, shouldn’t the TARP funds be used to provide liquidity to solid collateral that is simply illiquid, under the classic Bagehot remedy.
December 6th, 20084:31 pm at
The poster hit on the “fear of” quite implicitly. Investors fear that they do not know what the future high growth sectors are. The uncertainty in identifying high growth sectors is that measurement by money is unreliable at the moment. Unreliable because the banks just finished investing in the wrong sectors, and now they have to use government to re-monetize their path to the successful sectors.
December 7th, 20081:18 pm at
bubbles… end when cash flows to finance the bubble are inadequate to carry the assets in the bubble
I think that can be operative to a Treasury bubble. It would well last until the Treasury has issued so much debt that tax payers revolt. If that is the case, this could last a lot longer and end a lot uglier than anyone is currently considering.
Unfortunately I don’t know what signs to watch for to test if that is the case.
December 8th, 200812:36 am at
Accrued Interest (http://accruedint.blogspot.com/2008/12/port-authority-you-overconfidence-is.html) has great coverage of the problems behind the failed NJ/NY Port Authority issuance, but the end of this Bloomberg article (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=apiJ2jG6NvJw) really hits on what you’ve been saying.
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The Port Authority’s taxable notes would compete for demand from investors also considering more than $15 billion of three- year securities sold by banks with recently approved guarantees from the Federal Deposit Insurance Corp.
Mary Talbutt-Glassberg, a vice president at Devon, Pennsylvania-based Davidson Trust Co., with about $1 billion under management, said she opted not to pursue the Port Authority bonds.
“I would feel better if there were definite financial support on the deal,” such as insurance like that provided by the FDIC, she said.
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