The Plumbing of the Financial System: Debt Markets and Structured Products
by John E. Charalambakis
Over the course of the last few months official foreign accounts have been selling US Treasuries. At the same time, the US Fed has been selling Treasuries to its primary dealers whose inventory of government bonds is rising. Moreover, newly issued paper (a.k.a. on-the-run paper) by the Treasury is selling at a premium vs. older paper (a.k.a. off-the-run paper) beyond normal amounts. The problem with these facts is that primary dealers’ inventory is not turning over quickly, which is a sign of liquidity issues in the market.
If these issues continue in the near future, then one of the most important elements of US markets (that is, to be deep and wide enough to provide liquidity) is at risk, if dealers cannot offload the paper bonds they carry in their inventories. Furthermore, per Bloomberg’s recent report, as the dealers try to hedge their positions they affect the futures and swap markets which in turn exacerbates the problem. The graph below shows the recent piles of debt instruments acquired by the dealers.
Therefore, the plumbing of the financial system faces another sword – besides the collateral holes, the inverted credit pyramid, and the other issues we have recently elaborated about, more information – which will appear from time-to-time given the unorthodox monetary policy implemented around the globe.
Let’s not forget that last October the debt markets experienced a flash crash which – when considered in the context of volatility and lower market liquidity – has the potential of shaking up debt markets, the duration of bonds, and especially the pricing of structured products. When debt securities are shaken, the role of market makers is to “warehouse” risks. Our fear is that such capability is being diminished and that in turn is clogging the arteries of the financial system and reduces its cushions during times of turmoil. (Let’s not forget that when the flash crash took place last October, volatility increased at historical levels not seen for 50 years).
On top of this given the massive inflows into bond funds, we could say that when investors’ appetite for debt wanes, the bond markets could be shaken up which will effect other markets.
We have been accustomed to financialization – the phenomenon of collateralizing and securitizing future obligations and then creating a myriad of derivative instruments upon the newly creating securities – which is a machinery that perpetuates debt accumulation rather than real production. As a result we have been condemning ourselves to lower productivity and to a slower economic growth rate.
Even if central banks resort to newly manufactured tools – it cannot be a coincidence that lots of articles in the last two weeks advocate helicopter money which is nothing but the direct financing of government deficits – to avoid or cushion another crisis, the reality of short term problems, along with the long term issues we have been discussing and the forthcoming pension crisis (public pension plans around the globe face $78 trillion of unfunded liabilities, while private sector plans in the US and the UK face a hole of more than $500 billion in the next 5-10 years), make us very skeptical of debt instruments and their effects on the overall market.
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