23 Mar WILL THE LIQUIDTY CRISIS MORPH INTO A SOLVENCY CRISIS?
According to Bloomberg last week was the most volatile week in history. In my view the greatest risk at hand is the liquidity issue morphing into a solvency issue. I would like to use the $3.9 trillion municipal bond market as example of how trading has almost completely broken down in the fixed income markets.
In two weeks, frantic waves of selling have pushed yields even on the safest securities up as much as five-fold. Prices have tumbled the most since 1981 according to Bloomberg.
The steep sell off risks creating a self-reinforcing cycle, as individuals stung by losses pull out more money, triggering new round of forced sales that could deepen the losses further.
The greatest losses are occurring in the shortest maturities and Friday it was announced the central bank would provide a limited role by extending its lending program to money market funds that own the short dated municipal bonds.
As noted above, municipals are regarded as “conservative” and yields Friday surged 75 basis points on short dated bonds and over 50 basis points on 30-year bonds.
The carnage in the corporate bond market is worse.
According to Bloomberg, there are $126 billion of bonds in the US investment grade index that are now trading at distressed levels. That is 4% of the index and two weeks ago such was nonexistent. Bloomberg writes any level over 1% is considerable as remarkable.
At this juncture it is a liquidity issue. But if liquidity issues continue it will morph into a solvency issue.
The trading system is broken, the result of Dodd Frank that decimated market trading mechanics. As much as I abhor government intervention, such is needed. In my view the financial meltdown ended in March 2009 when the Mark to Market accounting was ended. [Mark to market accounting was the result of Sarbanes Oxly and Enron…sowed the seeds of the next crisis]
Today’s liquidity issues can end immediately by permitting money center banks to again take risk-based positions. Will this happen? If it gets ugly enough, yes.
Changing topics, Goldman is suggesting second quarter annualized GDP to drop by 24%. Earlier in the week it was estimating a 5% decline. Goldman writes a surge in layoffs and collapse in spending are at historic speed and size with unemployment rising from 3.5% to 9%.
The firm believes the rebound will be V shaped as growth will rebound by 12% in the third quarter and 10% in the fourth.
This too shall pass but like many I am shell shocked.
What will happen this week?
Last night the foreign markets were down. London was down 3.88%, Paris down 3.18% and Frankfurt down 2.99%. China was down 3.11%, Japan up 2.02% and Hang Sang down 4.86%.
The Dow should open about 2% lower. There are frightening stories emerging from the bond market with even the most anti interventionalists suggesting government must now intervene to provide liquidity via the direct purchase of corporate and muni bonds.
As stated this too shall pass and we will emerge stronger but wow like most I have a pit in my stomach. The 10-year is up 14/32 to yield 0.81%.
