by Steven Slezak, an analyst at Global Risk Insights
Anything is possible but not everything is likely. An impending bond market liquidity crisis combined with softening inflation was once thought a remote possibility. No more.
Walter Bagehot argued in 1873 that the role of a “lender of last resort” during a financial crisis is to lend freely to its dependent institutions, but only at penalty rates, and only when good collateral is offered. Institutions that cannot survive under this regimen are allowed to go under. He had a low opinion of “too big to fail,” a problem he described 160 years ago.
Bagehot might have been interested in two storylines that emerged in the last couple weeks on inflation, interest rates, and the bond markets.
Storyline 1 was set off by a September Euromoney report by Peter Lee – a liquidity crunch appears to be developing in the bond markets. Now, the term “bond fund crash” is not one to be employed loosely in financial circles. Neither does one like to hear “the great bond liquidity drought“ thrown about. The Euromoney story was picked up by everyone from Felix Salmon at Reuters, to Deus Ex Macchiato, to FT Alphaville’s Izabella Kaminska, who hinted of “immobile dark inventory stores” of debt in a delightfully sinister tweet.
The alarms may be well-founded and credible, but none commented on Storyline 2, which was the cover of The Economist US edition — the fall of inflationary pressures and the specter of deflation in the US and Eurozone economies.
Each on its own is a frightening tale. Combined, they portend real trouble. Could a liquidity crisis push the Eurozone or the US into deflation? Is there a risk of both occurring?
At present, the value of US credit mutual fund assets (holding investment grade and high yield debt) outstrips the value of all broker dealer inventory in the bond markets by about $830 billion. If for some reason interest rates were to rise, those stampeding for the exits would find the broker dealers, whose role is to make the secondary market in bonds, unable to provide liquidity.
Given the increased liquidity premium that would result, rates would rise more, leading to even greater selling pressure. Under these circumstances, central banks could find it difficult to hold the zero lower bound. Unless someone provides liquidity, a vicious cycle would ensue.
The following chart from the St. Louis Federal Reserve shows the consumer price index for the US and Europe for the last ten years. Japan’s numbers are thrown in for sake of comparison. You can see why The Economist is concerned inflation is stalling out.
So what might happen if a liquidity crisis in bonds leads to deflation?
[See Related: Eoin Treacy: Markets at a Pivotal Moment; Bull Market in Bonds Likely Over]
In this scenario, the drought would cause liquidity premium to rise. If deflation were to follow, inflation premium would become negative. If liquidity premium rises to the same extent inflation premium goes negative, the net effect is zero. But there is likely some lower limit to the deflation rate. The same is not necessarily true for the liquidity premium, which could be hefty if a drought threatens.
We would expect interest rates to rise overall and bond prices to continue to fall. Because it reduces the value of cash flows debtors use to pay off creditors in the future, inflation favors borrowers. Deflation, however, reduces credit demand. Why spend now when prices are falling and debt is getting harder to pay off?
Basically, a credit crunch could follow. This time around, borrowing would not be easy, even for sovereigns. Why? First, sovereigns will find it difficult to roll over their debt when it comes due.
Second, for risk-free debt like US Treasuries, the liquidity premium and default risk premium are believed to be zero. Ordinarily, these are charged only to more risky corporate debt. But these are not ordinary times. An article in the Summer 2012 issue of The Journal of Fixed Income concluded that a default risk premium is now attached to US Treasury debt. No doubt a liquidity charge would be levied against “risk-free” debt during a liquidity drought.
Before the Great Recession, risk-free debt was considered risk-free because liquidity premium (LP) and default risk premium (DRP) were zero. The spread between the risk-free rate and a risky rate used to be absolute: LP + DRP. But now we are talking about the relative difference between the risk-free rate’s LP + DRP and the risky rate’s equivalent. What’s the distinction then between risk-free debt and risky debt if LP and DRP for both are greater than zero? The essence of “risk free” would evaporate.
Would we find risky corporate debt carrying lower interest than supposedly risk-free debt? Indeed, this has already occurred. The FT pointed out in 2011 that 70 American corporations enjoyed lower borrowing rates than the US Treasury did at the time.
Which brings us back to Bagehot. If the secondary market cannot provide liquidity, bond investors (Blackrock and Pimco are the biggest) would be forced to sell assets at deep discounts. Not all bond funds would have good or sufficient collateral to offer and some would fail. Falling bond values would impact almost all investment portfolios and other asset classes, from mutual funds to pensions, from insurers to bank collateral. Meanwhile, rising rates would lead to a general decline in the value of other assets, deepening deflationary pressures and the most sound collateral, sovereign debt, could be burdened by both default and liquidity premia.
How long until the lenders of last resort get involved, especially if the contagion cannot be contained? Bagehot’s advice was ignored during the last financial crisis. We have witnessed the results. Bagehot cannot be ignored any longer.
