Analysis: Dwindling bond liquidity means Italy shock may be just a warning tremor

Liquidity hiccups have already roiled emerging and junk-rated bonds in recent years. But Italy's upheaval at the end of May showed that parts of the vast, historically stable market for Western sovereign bonds has also become prone to seizure whenever turbulence strikes.

"What happened in Italy should teach portfolio managers that liquidity comes at a price," Arnaud-Guilhem Lamy, a fund manager at BNP Paribas, said.

Euro zone government bond trading volumes have nearly halved in the past four years to 676 billion euros in June, from 1.29 trillion euros in June 2014, data from Trax, a unit of bond trading platform MarketAxess, showed.

Meanwhile, the bid-offer spread -- the difference between prices investors quote to buy and sell, a common liquidity gauge -- remains low but has widened. Even for Germany's 10-year Bund, the region's most-traded bond, bid-offer levels on cash prices are now 15 to 30 cents, compared with 5 to 10 cents from 2013 to 2015.

Some of that slide was caused by the European Central Bank. Its 2.6 trillion-euro bond-buying scheme has swallowed a big chunk of new supply since 2015.

With bond purchases ending this year, many expect liquidity to improve. That seems to have happened in US markets since QE ended there. The average daily Treasury volumes in the first five months of 2018 rose 4.7 percent from the same period in 2017 to $554.3 billion, trade body Sifma says.

But broadly, the liquidity drought is also symptomatic of a bigger problem after new rules effectively forced banks to reduce the pre-crisis "market-making" practice of holding bonds on their own books until buyers appear to lubricate trading.

The Basel III rules, drawn up in 2009, forced banks to hold more capital against the risks they took, in turn making it costlier to hold inventories.

Many see this as actually increasing market vulnerability. In the May 29 blowout, when buying interest for Italian debt evaporated, bid-offer yield spreads ballooned, peaking at 30 basis points versus 0-5 bps in normal times.

Several banks have stepped back from primary dealing roles, partly due to regulatory pressures..

"The role of market makers is still important, but you cannot rely on them," Lamy said.

Some also blame the growing role of computer-powered high-frequency traders as market makers in place of banks; they are often accused of stopping quoting prices when spreads widen sharply.

There are signs of reduced liquidity in the $5 trillion-a-day currency market, too. The sterling "flash crash" in October 2016 and the Swiss franc surge in January 2015 are prominent examples of recent liquidity squeezes. But two London-based bank FX trading heads said mini intra-day "flash crash"-style moves occurred far more frequently than investors realised.

Twice this year, the number of multiple standard-deviation moves - measuring unusually large price changes - across major bond, FX and stock markets has passed levels that were exceeded only twice in the preceding five years, Japanese bank Nomura estimates.

"All these bank risk rules ... means that some banks, when a certain security goes above a certain volatility, they stop quoting it," said Said Haidar, CEO of New York hedge fund Haidar Capital Management. "That means some of the market-makers disappear from the market when you need liquidity most."

BALLOONING SPREADS

Of May 29, as fears grew that Italy would quit the euro, dealers at banks and hedge funds painted a picture of a market in panic mode. The spike in short-dated Italian bond yields was the biggest since 1992, surpassing any day during the 2009-2013 European crisis.

Kaspar Hense, a fund manager at $61 billion BlueBay Asset Management, said he watched Italian bid-offer spreads surge to between 15 and 20 basis points from the normal 2 to 3 bps as buyers and sellers disappeared.

"Normally you wouldn't even trade an asset with that sort of spread," Hense said.

Even now, selling a big tranche of Italian debt, say $200 million worth, remains near-impossible and "fruitless", said Louis Gargour, CIO of hedge fund LNG Capital.

That was not the case in previous years, Gargour said, adding: "If you are a large fund, selling significant amount of BTPs (Italian government bonds) into market weakness is difficult and is likely to exaggerate price moves against you."

DISAPPEARING INVENTORY

Current data on European banks' bond-trading inventories is difficult to find, but the Bank for International Settlements estimated in 2016 that U.S. primary dealers had cut net Treasuries positions by nearly 80 percent since 2013.

And dealers' holdings of US corporate bonds are now less than one percent of the total outstanding, versus 10 percent in 2008, Gavekal Research said.

What's of concern is that recent episodes of disappearing liquidity -- February's volatility spike and a late-2016 sterling "flash crash" - happened during a multi-year bull run on world markets.

Now with economic growth possibly slowing and central banks withdrawing stimulus, the next hit may strike when the market backdrop is less benign.