Anthony Peters, SwissInvest strategist
ONE OF MY junior colleagues asked me last week why the markets were so quiet. Was it, he wondered, because people couldn’t work out exactly what the economy was doing and where monetary policy was headed?
Well, I’ve been plying my trade for 30-odd years and the exact state of the economy or the central bank’s precise monetary intentions have never really been clear. If they had been, we wouldn’t have got so excited when releases hit the screens.
In fact, I explained to the young man, the real reason for the unnatural quiet is that coupons are so low.
He looked at me quizzically, so I asked him where 10-year Treasuries were trading. Check screen: 2.65%. Next question was by how much 10-year yields would need to rise in order for the price of the 10-year to move down by 2.65 points. The answer to that, with the 10-year note sporting a modified duration of 8.64, is 30bp on the nail. Next question was how many months of interest income is lost when accounting for a 1/2-point bid-ask spread? The answer to that is around 2-1/2 months.
The point I was trying to make is that the frictional costs of trading are pretty high relative to the coupon income on a fixed income portfolio and that, with the average yield on the whole Treasury curve close to 2%, the best way of generating any sort of performance is not to rack up costs.
It’s bad enough having to pay management fees, custody fees and all the sundry fees that go to the index providers without offering up a good living to the broking community.
Are people not trading because markets are illiquid or are markets illiquid because people aren’t trading?
THERE IS AN associated chicken and egg question here. Are people not trading because markets are illiquid or are markets illiquid because people aren’t trading?
If frictional costs are high, people won’t want to trade, but market-makers’ ability to make tight markets is a function of the ease with which they can turn over positions. The less clients feel prone to trade, the less dealers will be prepared to take risk and, if they do, they will want to be paid for it. So, we enter into a vicious cycle where illiquidity begets illiquidity.
Most of the relevant best practice, regulation and legislation either developed or was created in a very different environment – we’re at the end of a near 35-year interest rate move, after all – which, I believe, cannot cope with the changes that have taken place in fixed income markets, be that rates or credit, in the past 12 months.
Generating positive total return is hard enough in a bear market but making something pay any return at all with two-year yields at 0.35%, three-years at 0.64% and five-years at 1.42% is already hugely tough without having trading desks nailed to the wall by nominal funding costs close to or even above carry.
MARKET-MAKERS DON’T make liquidity. They broke it. Liquidity is made by the presence of active buyers and sellers. With them absent, the rest of the system falls to pieces.
Volumes and market liquidity, the chicken and the egg, will most likely not return until the cost of doing business as a proportion of total return diminishes enough to become justifiable again.
For this, either volumes have to rise in order to generate higher liquidity or the regulatory environment needs to be loosened up a bit.
Failing that, we’ll have to see nominal rates at levels that enable investors to move securities in and out of their portfolios without wiping out most of the interest income.
On the other hand, a nicely steep yield curve with lots of roll-down and sufficient juice to make regular extension trades to offset portfolio time decay worthwhile will keep firms with solid index-tracking real money relationships busy enough to make a decent living, even if it doesn’t exactly make them rich.
Do I see a significant improvement in market activity in the near future? I think we all know the answer to that question. Meanwhile, I’m off for a snooze. Wake me up if there are any deals to do.