John Maynard Keynes, one of the greatest investors of all time in addition to being a famous economist, liked to describe stock and bond speculation as a beauty pageant. But in the Keynesian beauty pageant, we’re not judging the beauty of the contestants themselves. Rather, we’re really judging the judges, and attempting to figure out which contestants the other judges will vote for. What, after all, is the price of a security if not a representation of what our fellow judges are willing to pay for it?
Which brings me to the talk of the markets these past few weeks: Lack of liquidity.
Jamie Dimon worries about liquidity in the bond market. So does Gary Cohn. So does Stephen Schwarzman. So does Nouriel Roubini. So do bond market participants in virtually every category, from munis to corporates to agencies to Treasurys. These judges, if you will, are concerned that because Wall Street has essentially become regulated out of proprietary trading in fixed income, that when bids are needed, they won’t be there. There is a fear that the new buyer of fixed income – the mutual fund, the ETF and the hedge fund – will jump out of the way as prices come down, thus creating a cascade or a shit spiral where people dump assets because they assume their competitors will also be dumping assets and they’d rather sell first than sell second or last.
That’s your Keynesian Ugly Contest at work – market participants stop paying attention to the bonds themselves, and start to sell today what they think their fellow judges will sell eventually.
Meanwhile, it’s worth pointing out, as Ben Carlson did last month, that there is always the threat of illiquidity. No one gets invested in an asset with any kind of guarantee about what the market will be like to sell into down the road. Even with a counterparty guaranteeing to buy it back from you, you’re still at risk of that counterparty being insolvent when the time comes.
It’s also worth pointing out that, so far, there is no actual liquidity problem in mainstream fixed income asset classes. Here’s Peter Boockvar on today’s Treasury auction, which went off without a hitch despite yields being at 9 month highs:
With yields at the highest level since October, the benchmark 10 yr note auction was very good as the yield of 2.461% was below the when issued of 2.47-.475% and the bid to cover ratio of 2.74 was a touch above the previous 12 month average of 2.68 and the highest since December. Also, direct and indirect bidders took a total of 70% of the auction vs the one year average of 63%.
Now of course, those are Treasurys, which will be one of the last things to face a liquidity problem. But every day corporate issuance goes off without a hitch precisely because of how much liquidity is spilling over from the sovereign bond markets into higher-yield debt. And while corporate yields are higher now than they were, there is no shortage of buyers – even if it takes a bit longer to match them than it did when the Fed was QEing everything in sight.
Howard Lutnick, CEO of BCG Partners (the old Cantor Fitzgerald), explained that while Wall Street banks have many fewer traders, those traders haven’t been vaporized, they’ve simply set up shop at smaller firms backed by hedge fund or private equity capital. “It’s the same people in the bond market, they just have different jobs.” Let’s hope he’s right – that the market is simply more fragmented these days and, as such, requires a bit more effort.
So while it’s good to maintain an awareness of the market’s liquidity concerns, it’s not like the TED Spread is blowing out or anything.
The bottom line?
If enough traders grow concerned with the concerns of other traders, they will surely end up causing the very thing they fear.
If enough people believe there could be a liquidity crisis, then there will be a liquidity crisis.
But we’re not there yet.