Declining Liquidity In The Most Liquid Markets?

Even these have been affected by Post-Crisis regulations 

by Ron D’Vari, CEO, & Timioth Bernstein, Analyst, NewOak

It is well known that fixed income liquidity and trading volumes have declined since the credit crisis. However, it is particularly disconcerting that the stringent post-crisis regulatory regime has significantly affected even the most liquid markets, including Treasuries and agency mortgage-backed securities (MBS).

The lower liquidity in some of the most liquid instruments will significantly restrict the overall financial markets’ resilience in times of crisis. For example, there would be a significant drop off in volumes and a spike in spreads across all products just when liquidity would be needed most by the investment community. Everyone is anticipating an interest rate move by the Federal Reserve (the Fed) sometime in 2015.

We expect that an actual Fed move will test the markets overall resilience and reveal market structural issues created by the new regulatory stringency. According to J.P.Morgan research (Matthew Jozoff, et. al., May 1, 2015), agency MBS trading volumes have fallen by half since the beginning of the credit crisis and now stand at $200 billion per day, down from a peak of $350 billion based on SIFMA data.

Refinance activity and tigher underwriting big factors

The overall size of the mortgage market on a net basis has been fairly stable and not grown due to lower refinancing driven by negative home equity and tighter mortgage underwriting standards. However, market structural changes, the Fed’s quantitative easing and lower dealer participation have impacted mortgage market liquidity.

In addition to fixed income investors, other key players in the MBS market are the Fed, government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, mortgage servicers as well as primary broker-dealers. The role of the dealers is to intermediate flows among market participants. The Fed has steadily increased its MBS position to $1.7 trillion, and GSEs’ retained MBS portfolios have been fairly stable.

Net-net, this has reduced the size of available MBS bonds significantly. In addition, the servicers hedging activities also have been falling due to a more benign prepayment environment. In turn, the dealers have become more reluctant to take on the large positions required to keep the MBS market liquid.

The significantly lower dealer participation is a direct consequence of the tighter regulatory grip (Basel III, Volker Rule) and Comprehensive Capital Analysis and Review and liquidity risk management. As a result, there are fewer active dealers carrying fewer inventories.

Fixed income managers are measured versus various fixed income aggregate benchmarks (e.g. Barclays Capital Aggregate Bond Index) that include all specific-pool agency MBS bonds outstanding. To add value, active managers have to take on tactical positions relative to their bond benchmarks that need to be traded in and out. Active fixed income managers often use MBS to-be-announced market (TBA) instead of trading specific pools to position and express views on the overall direction of agency MBS, relative coupon performance or MBS basis vs. U.S. Treasuries.

The majority of the mortgage market volume drop has been in the daily TBA trading. The significantly lower available liquidity in TBAs has made it a lot more challenging for larger and more active fixed income managers to add value through relative value trading and positioning since it makes it costly to exit large positions once established. Given the anticipated Fed interest rate move in the fourth quarter of 2015, most managers have lowered their risks relative to their benchmark, further lowering volatility and volumes. The current market calm is artificial, is the direct result of regulatory trends, and so could change at any time.

ALSO CONSIDERED
Euro-Twist: Mexico's New Century Bond?

by Timothy Bernstein

April brought big news from our neighbors to the south, as Mexico issued its first 100-year “century” government bond denominated in euros.

Mexico’s initial issuance, valued at 1.5 billion euros, was priced at a yield of 4.2%. From the borrower’s perspective, this is a considerable discount from Mexico’s dollar- and sterling-denominated century bonds—both currently trading at around 5.3%, and issued with even higher yields. Yet the fact that Mexico would issue a century bond in this currency now, and at a yield of 4.2%, provides valuable insight into the current status of Mexico, the euro bond market and the U.S. dollar.

First, the yield itself, at just over 4 percent, manages to be both low enough to reflect positively on Mexico’s fiscal outlook and high enough to indicate just how robust Europe’s quantitative-easing program has been. Despite Mexico’s history as an unreliable debtor—the 20th century saw three distinct periods of default on external debt—the country received an ‘A’ credit rating from Moody’s in 2014, and last November renewed a $70 billion credit line from the International Monetary Fund.

Skeptics, many within Mexico itself, point to relatively anemic growth projections; according to The Economist, a poll of experts commissioned by the Bank of Mexico predicts average annual growth of 3.8% over the next decade. However, Mexico’s previous century bond issuances, in dollars and sterling, have continued to fare well in a volatile emerging-market debt climate, and the government has endeared itself to foreign creditors with initiatives to cut public spending and increase competition in Mexico’s energy sector.

Moreover, at a time when international investors are snapping up euro-denominated bonds with negative yields, essentially paying for the privilege of holding European debt, 4.2% yield almost constitutes a buyer’s market. Considering that in the current climate of negative cash deposit rates, a negative yield on high-demand debt is attractive in and of itself, it is not difficult to discern the appeal of 4.2% yield on the bond of a country with an ‘A’ Moody’s rating and successful track record of century-bond issuance.

Last but certainly not least is what the euro-denominated issuance tells us about emerging markets’ wariness of the U.S. dollar. As Manik Narain, an emerging-markets currency specialist at UBS, estimated to the Financial Times, up to 75% of emerging-market debt is currently dollar-denominated, rendering large swaths of the world very vulnerable to the U.S. currency’s strength. In that context, a highly publicized new bond issuance in a different currency might inspire other markets to diversify their financing away from the dollar.

Given the negative effect the dollar’s recent period of strength has had on global currencies, increased diversification could lead to an improved outlook for many of those currencies, and consequently increase investor enthusiasm for emerging-market debt across the globe. Only time will tell if Mexico is able to pay back the grandchildren of the investors buying their 100-year bonds; whether the euro will even exist in 2115 is far from a guarantee.

In the meantime, the timing of the issuance, and the currency in which it was issued, paints a fascinating portrait of Mexico’s international perception and the global currency market in 2015. How will that portrait change over the next century? That is the 1.5 billion-euro question.