The flood of easy money from the world’s central banks may be masking the risk that bond markets may be starved for liquidity when interest rates increase to normal levels, the International Monetary Fund (IMF) said.
Liquidity is tightening as banks become less willing to serve as market-makers amid tougher regulations and efforts by the financial industry to reduce risk, the IMF said in a study released on Tuesday.
“Structural changes, such as reductions in market-making, appear to have reduced the level and resilience of market liquidity,” although not at an alarming pace, the Washington-based IMF said.
As evidence of the market’s fragility, the fund pointed to events such as the flash rally in U.S. Treasuries in October 2014, when yields on benchmark 10-year bonds plunged before bouncing back on seemingly little market news.
There could be “a sudden deterioration in market liquidity and an increase in liquidity spillovers across asset classes” once central banks start tightening the flow of money, the fund said. “Market liquidity that is low is also likely to be fragile, but seemingly ample market liquidity can also suddenly drop.”
The IMF also cites the growing fixed-income holdings of mutual funds as a risk to liquidity in its study, which forms part of the fund’s latest Global Financial Stability Report. The full report will be released Oct. 7. Mutual funds have become “more prone to herd behavior” and less likely to absorb market imbalances, the IMF said.
Even the exceptionally loose monetary policy of central banks may be unintentionally sapping liquidity. Purchases of government bonds by central banks have made the debt less available to be pledged as collateral for repurchase agreements used by lenders for short-term funding. Liquidity in the repo market may be suffering as a result, the IMF said.
As the U.S. Federal Reserve prepares to raise its benchmark rate for the first time since 2006, “good communication and attention to liquidity developments across markets” will be important, the IMF said. “Central banks should take market liquidity into account when conducting monetary policy,” it said.
The fund urges regulators to standardize electronic trading and reduce the “first-mover advantage” of investors who pull their money from mutual funds.
“Regulators should consider using tools to help adequately price in the cost of liquidity at mutual funds,” the IMF said.
Market regulators should also examine restrictions on trading derivatives, the IMF said, citing the negative impact on sovereign-bond liquidity of the European Union ban in 2012 on uncovered credit-default swaps.