By Pam Martens: December 9, 2014
After being up as much as 2.4 percent during the session, China’s Shanghai Composite Index plummeted over 8 percent in heavy trading in a two-hour period overnight, finally closing down 5.4 percent. At least one trigger for the rout was an announcement by a stock exchange clearing agency in China that lower-rated bonds will no longer be allowed as collateral for repurchase agreements, a move that instantly impacted credit market liquidity and sent sellers into the stock market to raise cash, according to a report at Bloomberg News.
China is far from the only country or market regulator that is worried. On November 25, 2014, the International Capital Market Association (ICMA) released a study by Andy Hill on the European corporate bond market which found that “A commonly held view is that a correction to the credit rally is inevitable and is likely to be severe. Some see the lack of liquidity in the secondary markets as exacerbating any correction, while others are more concerned about how a non-functional secondary market could impede any return to normality.”
An “overarching” theme coming out of interviews for the study, said Hill, was a “decline in secondary market liquidity. The only variation seems to be in the degree to which it has reduced, ranging from ‘significantly’ to ‘completely’.”
Over the past two months, concerns have also grown louder in the U.S. On November 24, 2014, Fitch Ratings released an analysis titled “Hungry for Return, Bond Managers May Starve on Liquidity.” Fitch found that “Despite indicators of reduced market liquidity for corporate bonds, most bond managers have not increased the level of liquidity they hold in their portfolios due to an aversion to ‘cash drag’ on fund performance. Limiting cash drag may allow some fund managers to avoid underperforming their benchmarks for 2014, but it can eventually expose funds to bouts of market illiquidity and exacerbate fund losses during market shocks.”
The Fitch study looked at data through the second quarter of 2014. A more recent analysis by Morningstar, as reported by Katy Burne on November 30 in the Wall Street Journal, suggested that at least the top 10 U.S. bond funds are heeding the warnings and increasing the amount of cash they might need for redemptions. Burne reported that these largest funds “held an average 6.6% of their portfolios in cash at their latest reporting date” according to Morningstar, an amount that was “double the sum they set aside last year and the most since 2007.”
Liquidity difficulties in bond markets tied to the energy sector or junk bonds is also showing up in widening yield spreads, according to Morningstar. On December 8 the company reported that “Within our investment-grade bond index, the energy sector widened out 10 basis points last week and has widened out 52 basis points year to date. Similarly, the average spread of the Bank of America Merrill Lynch High Yield Master II Index widened almost 13 basis points to +477. Within the high-yield index, the energy sector had widened +100 basis points last week to +687 and has widened 300 basis points year to date.”
In decades past, overnight fallout from Asian stock markets would spread its contagion through our markets – at least at the open. But more recently, U.S. markets have behaved oddly – finding an abundance of rosy outlooks to get past foreign troubles and rally on the day.
Interestingly, this morning’s U.S. futures on the Dow Jones Industrial Average reacted to the overnight foreign selloff in the way U.S. markets previously behaved before dark pools, high frequency traders, and multi-billion dollar hedge funds ruled the game.
Before sunrise, futures were down 60 points; an hour later, they were down 122 points; a little later, down 156 points. A reassessment of risk and liquidity would appear to be in vogue again.