Head­ing off bond mar­ket tantrums

The Pak Banker - - OPINION - David Ship­ley

Some­day soon, maybe ex­actly one month from to­day, the U.S. Fed­eral Re­serve will raise in­ter­est rates for the first time in nearly a decade. How the bond mar­ket will re­act -- an en­tire gen­er­a­tion of traders was in grade school the last time rates went up -- is a ques­tion that has a lot of peo­ple wor­ried. Whether this anx­i­ety is jus­ti­fied is a sep­a­rate ques­tion from what the Fed should do about it. To its credit, the Fed has been try­ing to head off any mar­ket dis­rup­tion by painstak­ingly broad­cast­ing its plans for more than a year. Mar­kets have a habit of mis­in­ter­pret­ing the cen­tral bank's state­ments, how­ever, and it may well be that it and other reg­u­la­tors need to do more.

But first, about that anx­i­ety: Banks claim that post-crash reg­u­la­tion has forced them to hold fewer bonds in their in­ven­to­ries. In­ven­to­ries of cor­po­rate bonds are at an all-time low. The re­sult, banks say, is that the bond mar­ket will be nei­ther liq­uid nor sta­ble. Oth­ers claim that pre­dic­tions of a cri­sis are a ploy by the banks to loosen reg­u­la­tions. Shrunken in­ven­to­ries, they say, are sim­ply the re­sult of banks be­ing less in­ter­ested in the mar­ket be­cause it's now less prof­itable. Who's right will be clear soon enough. What's al­ready clear is that it's not nec­es­sary to take sides in the de­bate about bond-mar­ket liq­uid­ity to see the ben­e­fits of re­as­sur­ing in­vestors about bond-mar­ket liq­uid­ity. One rea­son anx­i­ety is so high is that, in re­cent months, mar­kets have hit in­ex­pli­ca­ble air pock­ets. On Oct. 15, for ex­am­ple, prices on 10-year Trea­sury notes took a 0.37 per­cent swing. Changes of that mag­ni­tude have oc­curred only three times since 1998. Pan­icky in­vestors yanked $68 bil­lion out of bond funds. Af­ter a 10-month in­ves­ti­ga­tion by five U.S. reg­u­la­tory agen­cies, the cause re­mains a mys­tery.

A pos­si­ble ex­pla­na­tion is the growth of al­go­rith­mic trad­ing, which is too fast for hu­mans to track. More than half of the trad­ing in Trea­suries is now done through al­go­rithms, so it makes sense for reg­u­la­tors to ex­plore whether they can pause trad­ing, pos­si­bly with cir­cuit break­ers sim­i­lar to those used in the stock mar­ket. But cir­cuit break­ers are hard to im­pose on the bond mar­ket be­cause, un­like stocks, most bonds don't trade on reg­u­lated ex­changes. The frag­mented bond mar­ket is another com­pli­ca­tion. Gen­eral Elec­tric, for ex­am­ple, has more than 900 out­stand­ing bonds, each with dif­fer­ent ma­tu­ri­ties, yields and prices. JPMor­gan Chase has about 1,700. Ad­dress­ing this frag­men­ta­tion will re­quire a longer-term so­lu­tion. In the short term, reg­u­la­tors could re­quire stress tests to make sure man­agers of bond funds are able to meet cus­tomers' re­quests to with­draw their money. Reg­u­la­tors, pos­si­bly with Congress's help, also need a more trans­par­ent mar­ket: Af­ter the Oc­to­ber rally, some reg­u­la­tors were sur­prised to learn that they have no vis­i­bil­ity into more than 40 per­cent of dealer-to-cus­tomer trans­ac­tions. In ad­di­tion, no fewer than six U.S. agen­cies over­see dif­fer­ent as­pects of the Trea­sury mar­ket.

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