Drowning in Illiquidity

The labor report was another clear indication of a domestic economy on its heels. There was weakness in nearly every component piece.The Treasury market is not trading as if it was a weak number as the market has retreated since the release of the report.

Traders report central bank selling of the 2 year note and mostly two way flow elsewhere along the curve.

In my continuing quest to document illiquidity I conversed with a Long Bond trader who decried the lack of liquidity in the bond contract and the note contract.

He noted that at one time in bond market history that the 10 year note contract traded often in 1000 contract increments. The market was deep and it was an effective hedging vehicle. He noted that while we spoke the bids and offers were only for a couple of hundred contracts and the depth once associated with that contract was lacking.

The situation is even worse in the bond contract but I will spare you the details.

Swap spreads are tighter by 12 basis points in the 2 year sector,6 basis points in the 5 year sector,5 basis points in the 10 year sector and nearly 8 basis points in the 30 year sector.

Mortgages lag swaps by 3/32.

In the long end of the swaps market participants are awaiting a trade which relates to the Lehman bankruptcy. My contact believes that as a result of the Lehman failure there is a universe of corporate hedgers and pension funds who have a need to replace duration in which they faced Lehman. He thinks that should serve to flatten the curve today.

Comments

[OilyGasMiner:]

John, we are gaggling in liquidity gasping for a breath of fresh air. Alot of companies are in essence, screwed. The LEH case, excuse me LEHMQ case does have alot of hedgers on their toes, as they attempt to liquidate what they have left. I'm proud to say that I am a LEHMQ holder from $.13/sh.

2008 Oct 03 01:10 PM

[ping kong:]

You r right!!!!
Let me add something

RT = RR + RE

Total reserves equal to required reserves plus resrves in excess, magic formula.
The reserves in excess, is the most important because it is one that directly affects the financial liquidity of an economy.
We could say that the sharp drop in the stock market started early in the third week of September.
Since then the U.S. banking system request 98 billion dollars, additional loans through the discount window; to finance the deficit in their cash flow.
The participants in this wave of loans, would be those involved in the mismanagement credit, those with bad accounts in the current assets, and stock dealer.
Those who have come to the windows of the Central Bank has generated growth, remarkable, in reserves in excess.
The creditor banks that received these payments and deposits, they decided to keep it as reserves at the Central Bank; with the intentions of restricting credit. Shortage of credits; drop in liquidity (M1, M2).
The effective rates of interest fed fund (not the same as the fed fund rate) have fallen in recent days, confirming the upward trend in reserves in excess.
Under this juncture there are two possibilities:
1.-If not adopted the "MEGAPLAN" of 700 billion, reserves in excess will jump dramatically, the effective rate fed fund would plummeted.
As a result, the FED would be obliged, in conjunction with the Treasury to sell bonds to reduce that excess reserves and maintain the effective rate in line with the target rate (fed fund rate).
The sale of bonds, on the other hand, the impact on other market interest rates, upward pressure.
2 .- If the plan is approved, the funds will go inmediately to reduce excess reserves, via repayment of the loans purchased from the discount window.
The central bank would recover its control over the reserves, the effective fed fund rate would remain at their level, there would be no need to intervene in the bond market.
On the other hand, the balance sheets of banks in difficulties, improve their equity; will recapitalize; cash flow positive. Accumulation of reserves, by the new restrictive credit policy. Again problems for the Central Bank; reserves in excess.
Here could emerge two scenarios:
If the Central Bank does not absorbs this excess reserves, which will lower the fed fund rate, and other financial institutions would use this cash to purchase bonds, keeping well, every interest rates at low levels.
If the Bank-absorbed, the fed fund rate would remain the same or maybe go up while interest rates will rise in all other markets.
Obviously, that the FED will have to absorb to be consistent with its current economic policy.
In conclusion, the rates of interest limp upward momentum, reducing the chances of recovery in consumption and investment. More and very prolonged recession. The new banking model that will has achieved in a patient process of restructuring. And while it lasts, the chances of an economic growth are restricted

2008 Oct 03 01:54 PM

[oldgoldbug:]

ping_kong : yeah whatever you said I agree! Seriously, you seem know your stuff; keep posting (but put some explanations in for the mortals here).

2008 Oct 03 02:41 PM

[Smarty_Pants:]

I know that there's all kinds of esoteric analysis of USGovt bill/note/bond rates/spreads/etc, but it just seems to be an overt focus on the minute details, sometimes without thought for the big picture.

I know lots of money is put into Gov't debt obligations and these anlyses are needed to manage the huge sums. Maybe it's just me, but it seems that putting a lot of money into Treasury debt is not a productive use for the savings the money represents.

The government produces nothing and is only able to repay the debt by taxing or borrowing more, neither of which advances the general prosperity as lending to a pofitable business would. The business repays the interest out of profits while providing a needed product/service to the public at large (else they wouldn't be profitable).

Doesn't the dumping of Trillions into government debt contribute to the lack of liquidity in commercial debt (and hence investment in productive enterprises)? At least to some extent?

2008 Oct 03 02:58 PM

[whidbey:]

Very interesting. One must watch CDS to see what is happening in the bonds. My read is that the bailout will take a long while to be felt and in the interval the case of nerves will go on.. and on.

2008 Oct 03 03:26 PM