Sunday, May 31, 2015

The QE distortion fact of the day

Ewen Cameron Watt of BlackRock summarizes the demand-supply gap created by the scarcity of safe assets caused by quantitative easing (QE). On supply, he estimates,
The G4 supply of “safe assets”, net of debt repurchases, should total negative $300bn this year, we estimate, compared with an annual run rate of $3.5tn before the financial crisis. The result? Abnormally low yields and highly correlated price changes in bond markets, both up and down... 
On demand, his estimates are,
price-insensitive buyers (Life-insurers and foreign exchange reserve funds) have some $40tn of assets under management. Even with a decline in foreign exchange reserves this year, the first in the past 20 years, they require an additional $3.5tn more each year to reinvest the proceeds of their maturing bonds, we estimate. And this is just to stand still!... (pension funds, endowments, and banks increasing 'safe' capital) manages some $20tn of assets... Our best guess for this group’s minimal reinvestment needs is $500bn a year. Together these two groups have reinvestment needs of $4tn of high-quality liquid assets a year. Supply, however, is estimated by us at just $700bn this year. This includes an estimated $1tn of new investment grade corporate bonds and a negative $300bn from governments. This creates a shortage of high-quality, liquid assets of $3.3tn. How is this need supplied?
And about the road ahead, he writes,
Assume the Federal Reserve and Bank of England stop reinvesting the proceeds of maturing issues while the European Central Bank and Bank of Japan press on with QE. The shortage shrinks to roughly $1.7tn, we estimate. It is not until 2017 that equilibrium begins to return. This ends at best in a bigger dose of indigestion than seen recently. At worst, an uptick in the supply of high-quality liquid assets or change in rates expectation sets in motion a vicious circle of selling.
Update 1 (07.06.2015)

Avinash Persaud points to the irony that while the GFC was caused by risky assets, the next one may be caused by a bubble in safe assets. He writes,
Determined to prevent a repetition of the crisis, regulators are forcing the holders of $100tn worth of assets the world over to buy debt from the most creditworthy issuers: companies and sovereigns with pristine credit histories, which comfortably generate enough cash to cover their obligations. After so many banks were sucked down by doubtful debt lurking deep within their portfolios, the impulse to usher them on to firm ground is easy to understand. But corralling a huge amount of capital into a narrow band of the market drives prices to perilous highs. Even if these assets were safe to start with, the enforced concentration is enough to make them risky.
These assets have become so over-valued that their only likely trajectory is downwards, inflicting massive losses all round.

Update 2 (07.06.2015)

Nouriel Roubini points to market illiquidity despite the liquidity flood of QE. He identifies four reasons - illiquidity induced by HFTs who dominate the trades and whose trading periods are concentrated; fixed-income assets are traded over the counter; fixed-income assets are mostly held in open ended funds, where exit is easy, and the combined effect of illiquidity and easy exit can cause sharp price drops; banks role as market makers in fixed income markets is being reduced due to greater regulatory standards like higher capital charges.

Update 3 (13.06.2015)
The FT has two graphics that capture the problem. The first shows the sharp rise in German Bund yields.
The second shows the decline in US Treasuries once QE started.
The holdings of corporate bonds with more than one year maturity held by US primary dealer banks has dropped dramatically from $235 bn in October 2007 to $38 bn in end-April 2015. 

As banks have been vacating the space, asset managers have started to take an increasing share of the market making activity in bond markets (under-writing government securities auctions and buying securities on behalf of clients). The mutual fund bond holdings of the ten biggest asset managers in fixed income group rose from $921 bn on 31.01.2008 to $1.98 trillion on 31.01.2015.

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