Bank of England (BoE) governor Mark Carney has been urged to explain what his team is planning to do to tackle declining liquidity in the bonds trade.
In a letter to the BoE chief, Treasury Select Committee chair Andrew Tyrie raised concerns that, by contrast with the “ample” liquidity climate that has prevailed since the mid-1980s, conditions are set to become “stretched” in the future, threatening the overall structure and stability of the gilt market.
Tyrie flagged up three pressing problems that the market is currently facing, mainly stemming from regulatory actions:
Tyrie wrote: “Market makers will be reluctant to bid until they have some confidence that the bottom has been reached. As a consequence, there may be large and sudden jumps in prices and yields.
“A ‘vicious circle’ of declining liquidity and financial distress among bond traders could be the consequence, affecting end investors and other gilt-market participants, too.”
He explained: “Liquidity is important to the gilt market, and it will continue to be important, not only to investors, but also to the government, which will need to finance the budget deficit, until it has been eliminated, and to refinance maturing gilts.”
In perhaps the most provocative part of his letter, Tyrie added: “The Bank will also need to unwind quantitative easing [QE] at some stage.
“This is an issue for both the Monetary Policy Committee and the Financial Policy Committee, as well as the Debt Management Office, because the way in which it is done will have implications for gilt-market liquidity and financial stability.”
Tyrie requested a ‘detailed response’ to his concerns, not just on the problems themselves, but the relationship between those problems and the status of QE.
Earlier this year, liquidity issues in the bonds market were the focus of a lengthy letter from JPMorgan Chase chief executive Jamie Dimon to the bank’s shareholders. In that document, Dimon questioned whether bonds would be in a position to help the financial community recover in the event of a new financial crisis.
“In a crisis, everyone rushes into treasuries to protect themselves,” he wrote. “But it seems to us that there is a greatly reduced supply of treasuries to go around – in effect, there may be a shortage of all forms of good collateral.”
Dimon explained: “The Federal Reserve owns $2.5 trillion in treasuries, which it has said it will not sell for now; and banks hold $0.5 trillion, which, for the most part, they are required to hold due to liquidity requirements… in the new world, these reserves are not ‘excess’ sources of liquidity at all, as they are required to maintain a bank’s liquidity coverage ratio.”
Interestingly, as The Treasurer reported last month, Federal Reserve governor Jerome Powell has also expressed worries over future ‘slumps’ in the bonds market.