Heading off bond market tantrums
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.