It’s Not Trade War Or A Market Drop That Is Keeping Credit Investors Up At Night

Two weeks ago, Morgan Stanley issued a report looking at the size of moves across all asset classes in the environment of declining market liquidity, and found that It’s not your imagination, large moves are becoming more common in the market.”

One week later, Goldman repeated Morgan Stanley’s warning almost verbatim, writing that “No – it’s not your imagination – earnings day moves are getting bigger.” Specifically, the bank found that the moves in stocks post their Q2 earnings reports experienced the greatest absolute amplitude on record, and more than 50% higher than the long-term average of 2.4% over the past 15yrs.

What was the common link between these two observations? Simple: the vanishing liquidity in the market, which has resulted in increasingly greater bid/ask spreads, as well a sharp decline in market depth, that has collapsed to levels not seen since the February VIXplosion (something Goldman also touched upon in “Market Depth Has Collapsed“.

Fast forward to today, when in the latest survey of European credit investors conducted by BofA’s Barnaby Martin, the strategist observes that concerns about the market’s ever shrinking liquidity have become the primary source of worry for professional investors, and as Martin writes, “it’s not trade wars or an equity market correction that look to be keeping credit investors up at night.” Instead, it is the fear of a “pervasive rush for the exit at some point in the future.”

In other words, what is keeping bond traders up at night is the fear that when the selling begins, there will simply not be enough liquidity to absorb it all.

What is just as surprising, is that just last month the top investor concern was “Bubbles in Credit”, i.e. excess liquidity, which one month later has now morphed into “Liquidity Vanishing”, which according to Bank of America is the first time in 3 years that this has emerged as the chief concern.

“Perhaps it just reflects the usual holiday slowdown in trading” Martin writes, however, as discussed in the above linked articles “one clear characteristic of the summer rally is how big – and random – spread dispersion has been  (especially high-yield).” Meanwhile, the growing number of “corrections”, or as Morgan Stanley calls them, “rolling bear markets“, being observed across financial markets in 2018, portfolios remain a challenge for investors to risk manage.

To Martin, this bizarre market evolution of stocks back to all time highs with far less underlying liquidity reflects what he calls “Paranoia in Credit Markets”, and leads to concerns of “a more pervasive rush for the exit by credit investors down the line.”

Broken down by product, 22% of high grade investors participating in the survey said their biggest concern was the evaporation of market liquidity, a fear shared by 20% of junk bond investors. Both are a sharp reversal from June when credit bubbles were the biggest fear for both sets of investors.

While bond investors have been spared some of the most violent moves to emerge from the Q2 earnings season, they have been more than exposed to the record volatility observed recently in Italian bonds, where following the surprise formation of a populist government, Italian debt plunged by the most on record, resulting in massive losses for numerous macro funds. Meanwhile, even as high yield yields plumb post 2007 lows, the market depth has continued to shrink and as the WSJ recently noted the bid/ask spreads on both IG and HY bonds have consistently leaked wider this year.

Echoing these concerns, Academy Securities’ head of macro strategy Peter Tchir told Bloomberg that “These sorts of moves are the basis of my concern about how little real liquidity there is in both directions, and how fragile the current market structure can be.”

So what are investors doing to placate these “paranoid” liquidity concerns? While Bloomberg recently noted that there has been an increase in CDS trading, either for hedging purposes, with first half CDS index volume rising to the highest level in 5 years, and JPM adding that derivative trading volume jumped 65% Y/Y in the first half of 2018…

… the product generally remains a mystery for a generation of credit traders (Citi recently poached a 32-year-old trader from Goldman to “rescue” its junk bond desk as few others there had any familiarity with trading credit default swaps following its demonization after the financial crisis) and with dealer swap inventories virtually non-existent, the bulk of traders have continued to use ETFs as a method to hedge their exposure. In this context, it is perhaps not surprising that as JPM showed, the short interest on global junk bond ETFs just hit an all time high.

Which in turn opens up a whole new can of worms: instead of lack of liquidity at the single name bond level, the next bond crash would likely see the ETF sector go bid- or offerless, a “phantom liquidity” danger which Howard Marks has been predicting since 2015.

Meanwhile, the underlying bond market continues to shrink: according to JPM, only 32% and 41% of U.S. high-grade and high-yield daily trading volumes takes place in the cash bond market.

But what is more concerning is that while at least some bond traders are keeping an eye on the exit, the vast majority of the market has been lulled into complacency, with the CFTC reporting that the net short exposure for VIX has risen to the highest level since the February VIX debacle.

In other words, while increasingly more investors are concerned about liquidity, virtually nobody is doing anything to hedge against an abrupt market “event” which could drain what little market liquidity exists overnight, resulting in an wholesale market freeze.

Why not? Because as the past decade has taught traders, spending money on insurance or protection remains punished, and after all, “the Fed has everyone’s back”, right? In other words, why hedge when the Fed will have no choice but to bail everyone out when the next crash finally happens…

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