The Next Big Threat: Illiquidity

Liquidity is the investor’s ability to buy and sell a security without significantly impacting its price. Lack of liquidity in a security can have its consequences. Post financial crisis regulations, such as Volcker Rule (Dodd-Frank), and Basel 3, has made it more expensive and more difficult for banks to store bonds in their inventories and facilitate trades for investors. Regulations designed to make the system more safer have depressed the trading activity.

Lack of supply is one cause for diminishing liquidity. Banks, the dealers of corporate bonds, have reduced their inventories. According to Bank for International Settlements (BIS), “Market participants have raised concerns that regulatory reforms, by raising the costs of warehousing assets, have contributed to reducing market liquidity and could be keeping banks from acting as shock absorbers during periods of market stress.”

Primary Dealer Net Positions (2006 to 2016) Source: MarketAxess
Primary Dealer Net Positions (2006 to 2016)
Source: MarketAxess

According to BIS, “US primary dealers…have continued to reduce their corporate bond inventories over the past years. Since the beginning of the year 2013, they have cut back their net positions in U.S. Treasuries by nearly 80%.

Another big cause of decreasing in liquidity is technology. A technology that has changed the structure of markets, high-frequency trading (HFT), an algorithm computer trading in seconds and in fractions of seconds, account for much larger share of the trading transactions and it leads to low liquidity. Majority of HFTs, if not all, reduces liquidity by pairing selected (self-interest), leaving out others. According to BIS, 70% of U.S. Treasury trading is done electronically, up from 60% in 2012. For both high-yield bonds (not highly liquid asset), it accounts for more than 20%. About 90% of transactions on bond futures take place electronically. I have no doubt electronic trading will continue to increase.

“Greater use of electronic trading and enhanced transparency in fixed income markets typically comes at the cost of greater price impact from large trades.”, BIS said in the report. Bonds now trade in smaller transaction sizes than they did before, “… large trades seem less suitable for trading on electronic platforms because prices move quickly against participants who enter large orders due to the transparency of the market infrastructure.” “It “discourages market-makers from accommodating large trades if they fear that they cannot unwind their positions without risking a sizeable impact on prices.”

BIS in its quarterly review report (March 2015) stated (source: FINRA’s TRACE data), the average transaction size of large trades of U.S. investment grade corporate bonds (so-called “block trades”) declined from more than $25 million in 2006 to about $15 million in 2013.

This is a sign of illiquidity since “trading large amounts of corporate bonds has become more difficult.” Trades facing constrained liquidity puts investors, especially large investors, to a disadvantage.

Capacity to buy/sell without too much influence on the market prices are deteriorating. Lack of liquidity can causes wild swings in the bond prices, which then can affect the rest of the financial markets. Today’s financial markets are so connected just like the economic domino effects.

They are connected, but let me tell you why they are so important. The U.S Treasury securities market is the largest, the most liquid, and the most active debt market in the world. They are used to finance the government, and used by the Federal Reserve in implementing its monetary policy. I repeat, in implementing its monetary policy. Having a liquid market – in which having no problem buying and selling securities without affecting the market price – is very important to the market participants and policymakers alike.

Examples of high volatility in a low liquidity:

  • Flash Crash (May 2010)

In a matter of 30 minutes, major U.S. stock indices fell 10%, only to recover most of the losses before the end of the trading day. Some blue-chip shares briefly traded at pennies. WHAT A SALE! According to a U.S. Securities and Exchange Commission (SEC) report, before 2:32 p.m., volatility was unusually high and liquidity was thinning, a mutual-fund group entered a large sell order (valued at approximately $4.1 billion) in “E-mini” futures on the S&P 500 Index. The large trade was made by an algorithm. The “algo” was programmed to take account of trading volume, with little regard, or no regard at all, to the price nor time. Since the volatility was already high during that time and volume was increasing, this sell trade was executed in just 20 minutes, instead of several hours that would be typical for such an order, 75,000 E-mini contracts (again, valued at approximately $4.1 billion).

May 6, 2010 - SPY Volume and Price Source: SEC Report
May 6, 2010 – SPY Volume and Price
Source: SEC Report
May 6, 2010 - SPY Volume and Price Source: SEC Report
May 6, 2010 – SPY Volume and Price
Source: SEC Report

According to the report, this sell pressure was initially absorbed by HFTs, buying E-mini contracts. However, minutes after the execution of the sell order, HFTs “aggressively” reduced their long positions. The increase in the volume again led the mutual-fund group “algo” to increase “the rate at which it was feeding the orders into the markets”, creating what’s known as a negative feedback loop. That’s the power of HFTs.

This was nearly 6 years ago. Today, there’s no doubt the power of the secretive section of the financial markets, HFTs, are much stronger and powerful and can destroy the markets with “one finger”.

With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.

Let’s not forget. Fixed-income assets such as, corporate bonds, are often traded over the counter in illiquid markets, not in more liquid exchanges, as stocks are.

It’s all about profits. Some, if not all HFTs, act the way they do, to make profit. There’s nothing wrong with that. But, the creators of the algorithms have to be ethical and responsible. It’s not likely to happen anytime soon since profits are the main goal (mine too) in the financial markets. So why should HFT “be fair” to others? I know I wouldn’t.

  • Taper Tantrum (2013 Summer)

In the summer of 2013, the former Federal Reserve chairman, Ben Bernanke, hinted an end to the Fed’s monthly purchases of long-term securities (taper off, or slow down its Quantitative Easing), which sent the financial markets, including the bond market into a tailspin.

On June 19, 2013, Ben Bernanke during a press conference said, “the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.” That sentence alone started the financial market roller coaster.

Yields skyrocketed. The gravity took down the value of greenback (U.S. Dollar). U.S. long-term interest rates shot up by 100 basis points (1%). Even short-term interest rate markets saw the rate-hike to come sooner than the Fed policymakers suggested. Borrowings costs increased so much, as the markets was expecting tightening of the monetary policy, it “locked up” the Fed from cutting the pace of bond buying that year.

Markets' Reaction To June 19, 2013, Ben Bernanke Press Conference Source: Federal Reserve Bank of St. Louis
Markets’ Reaction To June 19, 2013, Ben Bernanke Press Conference
Source: Federal Reserve Bank of St. Louis

This raises (or raised) whatever the market prices can handle orders that are executed in milliseconds. It points to a lack of supply (dealer inventories), A.K.A illiquidity. I feel bad for funds that have a lot of corporate-bonds in their portfolio. The struggle is real.

An open-ended funds that allow investors to exit overnight are more likely to experience a run, as market volatility increases. A run on funds will force the funds to sell illiquid assets, which can push down the prices lower and lower. Recently example of that is the Third Avenue (“investors’ money are being held hostage”).

Brace for a fire sale. Coming soon in your area.

Market makers, where are you? Come back. I need to sell the investments at a current price, before it goes much lower.

  • October 15, 2014

The financial markets experienced – as the U.S. Department of the Treasury puts it – “an unusually high level of volatility and a very rapid round-trip in prices. Although trading volumes were high and the market continued to function, liquidity conditions became significantly strained.”

On October 15, 2014, the markets went into a tailspin again. The Dow plummeted 460 points, only to recover most of the losses. The Nasdaq briefly fell into a correction territory, only to rebound sharply. The 10-year Treasury yield “experienced a 37-basis-point trading range, only to close 6 basis points below its opening level”, according the U.S. Treasury Department report.

According to Nanex, a firm that offers real-time streaming data on the markets, between 9:33 A.M and 9:45 A.M, “liquidity evaporated in Treasury futures and prices skyrocketed (causing yields to plummet). Five minutes later, prices returned to 9:33 levels.” “Treasury futures were so active, they pushed overall trade counts on the CME to a new record high.”, said the report.

“Note how liquidity just plummets.”

Liquidity in the 10 year as measured by total sizes of orders in 10 levels of depth of book. Source: Nanex
Liquidity in the 10 year as measured by total sizes of orders in 10 levels of depth of book.
Source: Nanex

Again, as I said, “Today’s financial markets are so connected just like the economic domino effects.” The mayhem in in the bond market can spread to the foreign exchange (forex) market.

October 15, 2014 - World Currencies Source: Nanex
October 15, 2014 – World Currencies
Source: Nanex

These types of occurrences are becoming common, or the “new normal”. As the Fed raises rates, the market participants will be adjusting their portfolio and/or will adjust them ahead of it (expectations), these adjustments will force another market volatility. But this time, I believe it will be much worse, as liquidity continues to dry up and technology progresses.

Recent market crashes and volatility, including the August 2015 ETF blackout, is just another example of increasing illiquidity in the markets. Hiccups in the markets will get bigger and will become common. Illiquidity is the New Normal.

Hello HFTs, how are you doing? Making $$$? Cool.

With interest rates around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt. With the recent rate-hike by the Fed, U.S. corporate bond market will experience more volatility. Lower and diminishing liquidity will “manufacture” a volatility to a record levels that the financial markets and the economy won’t be able to cope with it.  As said, “Today’s financial markets are so connected just like the economic domino effects.”, the corporate bond market volatility will spread to the rest of the financial markets.

Oh wait, that already is happening. Reversal of monetary policy by the Fed this year, as I believe the Fed will lower back rates this year, will make things worse.

Liquidity: Peace out!

GE’s massive makeover

Last Friday (April 10, 2015), General Electric (GE) announced a plan to sell off real estate and reduce the size of their financial business. They will be selling majority of GE Capital Real Estate assets for about $26.5 billion. GE will also sell away the remaining portion of GE Capital. It aims to complete the sale of GE Capital over the next two years.

GE’s financial unit is one of the largest financial entities, with assets of half a trillion dollars. It includes everything from consumer loans to property. When the financial crisis hit, earnings from GE’s finance unit collapsed. There were (still is) strict regulations on financial services. As a result, Jeff Immelt, CEO of GE, promised to shrink the finance arm.

Ever since the financial crisis, G.E. has taken small steps to shrink its finance operations. Last year, it spun off its private-label credit card business, known as Synchrony Financial (Ticket: SYF), for $2.9 billion initial public offering (IPO).

To who? GE said it would sell nearly all of its real estate portfolio to investors including Blackstone Group and Wells Fargo & Co for $26.5 billion. There are a further $165 billion of assets that needs to be sold. There will be buyers other than Blackstone Group and Wells Fargo & Co. The company plans to keep the finance assets directly related to selling its products such as jet engines, medical equipment, and electrical grid gear. Remember; Warren Buffett has a stake in both GE and Well Fargo. I believe Warren Buffett will be increasing his stake in GE.

Why now? GE is selling their real estate and financial business for two reasons. First, commercial real estate prices are up. Commercial real estate prices are higher today than it was before the financial crisis. Lastly, rates are still low. If the Fed hikes interest rates (cost of borrowing rises), it will be unattractive to finance any deal. Therefore, it’s a perfect time to take an advantage of the low rates and the high prices.

Source: http://www.greenstreetadvisors.com/about/page/cppi/
Source:       http://www.greenstreetadvisors.com/about/page/cppi/

GE is taking the right move, by focusing more on industrial sector. By beginning to sell $26.5 billion worth of real estate assets, GE will be returning to a kind of company it is supposed to be, an industrial company. GE’s operations include jet engines, oil drilling equipment and medical devices. I would not be surprised if GE makes industrial acquisitions, both small and big. I would not even be surprised if GE merges with another industrial business.

Investors are very happy with the deal, including me. General Electric’s stock (Ticker: GE) rose more than 10%, on a heavy volume, to $28.68, highest since September 2008. On Friday, more than 350 million shares (GE) were traded. GE expects to return more than $90 billion in cash to investors through dividends, share buybacks and the Synchrony exchange through the end of 2018. $50 billion will come from a share repurchase program, one of the biggest on record. As of January 31, GE had 10.06 billion shares outstanding. GE expects to reduce it by 20% to 8-8.5 billion by 2018. In the longer term, the stock price will continue to increase.

GE (General Electric) - Daily
GE (General Electric) – Daily

Not only GE wins here, but also Uncle Sam. GE will bring back $36 billion in cash that resides overseas and will have to pay tax to the U.S government, ranging from $4 billion to $6 billion.

GE said it would take after-tax charges of about $16 billion for the restructuring in the first quarter, with $12 billion being non-cash charges. It will reduce their Earnings Per Share (EPS). On Friday (April 17, 2015), GE will report their first quarter earnings.

GE expects that by 2018 more than 90% of its earnings will be generated by its industrial businesses, up from 58% in 2014.

Past & Future:

GE's past and future
GE’s past and future (source: http://www.ge.com)

 

 Note: I currently own shares in GE, which I brought last year at $25.83. I plan to hold on to it. I may even buy more shares. I believe GE’s share-price will reach $38 by the first half of 2016.

If you have any questions, feel free to contact me, and/or leave comments. Thank you.

UPDATE: Click http://www.outofwacc.com/ges-slight-positive-earnings-report-and-its-about-to-change/ or click here.