Markets Insight

June 3, 2015 5:07 am

EM most at risk from bond market ‘tantrums’

Gene Frieda

Any liquidity challenges in a sell-off will appear first in emerging markets

A trader point at a graphic on a computer screen in Lisbon on April 23, 2014 during the auction of Portuguese Treasury Bills. Portugal easily raised 750 million euros in a landmark 10-year bond issue at a sharply reduced interest rate today, market data showed. The funds, equivalent to $1.0 billion, were raised at an interest rate of 3.575 percent amid strong demand from investors, marking a crucial step on the country's road to emerging from an EU-IMF rescue programme on May 17. AFP PHOTO/ PATRICIA DE MELO MOREIRA (Photo credit should read PATRICIA DE MELO MOREIRA/AFP/Getty Images)©AFP
Because of high fees, the average investor does not see the fruits of managers' stockpicking labours
The recent volatility in fixed income markets has once again highlighted a “global warming” in financial markets: the price response to new events and data has become much more extreme due to changes in market structure.

This has occurred along two tracks. First, stricter regulation has led banks to cut capital devoted to intermediation, making liquidity more precious. Each unit of risk demands a larger amount of capital than in the past. As a result, volumes at a given price decline. In periods of stress, there is little liquidity on offer at a given price. If everyone wants to sell simultaneously, prices can move a lot more than standard risk models assume.

Second, new forms of liquidity providers have stepped into the void, with automated trading platforms particularly evident in developed bond markets. But unlike the banks of old, which warehoused securities on their balance sheet, the new providers are more skittish. Liquidity provision is prone to shift suddenly from feast to famine, and in turn, the instances of lightning strikes proliferate.

The good news is that, despite bouts of illiquidity, markets today are less fragile than in the past as financial system leverage has been reduced substantially. The bad news is there has undoubtedly been some negative impact on the price and quantity of credit provision. The open question is whether the changes have made markets more susceptible to shocks and prone to fragmentation.

As the exit from zero interest rates approaches in the US and the UK, this question is of paramount importance.
The fixed income market operates like a beauty contest: when returns are strong, as they have been in the post-crisis era, money flows in. In periods of negative performance, money flows out. And since three-quarters of all instances of outflows from fixed income funds over the past 21 years have occurred during Fed tightening cycles, the risk of outflows when rates rise is high.

Today, a larger swatch of the fixed income market is subject to beauty contest risk. Because credit spreads are so tight and “safe” sovereign bond yields so low, the buffer against any capital loss on bonds is extremely thin. A small rise in interest rates can generate losses across a large area of the fixed income market. Add to this the dearth of market-making liquidity and the riskier fringes of the credit market are likely to become dislocated.

Markets always fear a big sell-off, but does the current market structure problem pose a material risk to financial stability?

For developed markets, as long as asset managers are leverage-constrained, the maturity mismatch inherent in daily liquidity funds poses modest risk to asset owners and their agents, the asset managers. Global warming in financial markets may lead to more “taper tantrum”-like events. But even if there is a genuine bear market in bonds, discontinuities should be bearable as long as there is sufficient transparency in pricing.

For emerging markets, the outlook is less encouraging and reflects the dangers of looking at the market liquidity problem purely from the perspective of the lender/investor.
The maturity transformation into illiquid corporate and local currency fixed income investments creates a risk of sudden stops. The taper tantrum resulted in nine months of outflows from emerging market fixed income funds — and this was when the Fed was still easing policy. Imagine a material tightening in US monetary policy and it becomes difficult to see how many emerging market corporates and even some sovereign borrowers cope.

The same benefits to fixing the market ecosystem apply, but there are costs to having waited so long to address the issue. Any problems stemming from market liquidity challenges are likely to show up in emerging markets first.

The policy changes needed to address market liquidity imbalances are relatively modest, but urgent. Volatility and market dislocations, already a constant feature of the post-crisis landscape, are only likely to worsen as additional bank regulation kicks in.

Redefining what constitutes a liquid asset, upgrading pricing tools for illiquid securities and removing the subsidy of daily liquidity will go a long way toward preventing central banks from becoming a hostage to these ongoing changes in the market ecosystem.

Gene Frieda is a global strategist for Moore Europe Capital Management

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