Making a Market: Liquidity, Flows and Volatility

Recently, Federal Reserve officials and others have expressed concerns about market reactions to an impending increase in the fed funds rate—even if just a modest increase. Problems are already in place.

Credit Market Evolution: Never the Same River Twice

Market problems have already been set in place. Both the short end and the long end of the Treasury yield curve reflect the impact of manipulated interest rates—both in the United States and abroad—by central banks as well as by financial regulatory authorities.
Problems are two-fold. First, the mandated pursuit of a reduction in risktaking by financial institutions has led to fewer actors undertaking certain activities. A decline in liquidity provided by banks in the repo market (top graph) is not likely to be made up by other providers, yet the repo market is intended to be the integral tool the Fed will use to set the funds rate going forward. Moreover, the funds market itself (middle graph) is not as deep as it was prior to the Great Recession. Reduced liquidity would call for additional caution by lenders and borrowers and caution on the Fed’s part for any significant move in the funds rate.

Is There a Risk-Free Benchmark Rate?

The artificial demand created for sovereign government debt—both in the United States and abroad through increased capital requirements—has led to historically low sovereign debt yields, despite the questions surrounding the credit quality of such debt. Meanwhile, on the supply side, tighter fiscal deficits have been mandated in the context of fiscal austerity in Europe, while stronger economic growth, along with budget sequestration, has limited the floating supply of U.S. Treasury debt. As a result, sovereign interest rates no longer reflect a free market rate and, with a very limited floating supply of Treasuries, for example, any small change in rates, or expected change, has led to increased volatility in yields, as witnessed in 2013 and 2014 (bottom chart).

Volatility: Regulation Generates Rigidity

In an attempt to reduce risk, there has also been a move to reduce flexibility in the financial system through limitations on whom and how much of certain designated financial activities can take place. This generates certain rigidities and thereby such actions have increased, not decreased, risk and volatility and the potential for capital losses, even at low interest rates. Low interest rates do not mean there is less interest rate risk.

Market volatility, and thereby capital losses, would likely be higher in the future than what many have experienced or assume would be true. Banks will be less effective in acting as shock absorbers due to new capital and liquidity rules. Moreover, there is a reduced floating supply of U.S. Treasury debt that would act as good collateral in a crisis. Complacency on rate movements is overdone—small changes can generate big losses.