What's throwing markets out of whack?

The first and foremost reason for the dislocations in fixed income markets in the last few weeks is that the markets and the global economy are being hit by the coronavirus, the mother of all exogenous shocks. There’s no precedent that I’m aware of with the exception of the Spanish Flu of 100 years ago, but that was not chronicled or tracked in real time like this virus is. I think that’s both good and bad.

The information allows our governments to implement extraordinary measures to quell the virus’ spread. But it also allows market participants’ worst fears to be realized. Those of us outside the medical community have no context from an historical or professional perspective for the numbers we’re receiving about cases, contagion and mortality rates. It’s also difficult to extrapolate protective policies impact on the real economy.

This is the swiftest equity market correction in history, thus far outpacing 1929, 1987, 2000-01 and 2008-09 in its pace of decline. That’s translated into dysfunction in the liquidity of the U.S. Treasury market, the market for the so-called “risk-free" rate. Since the Treasury market is the bedrock of the financial system, that’s cascaded into dysfunction in the liquidity of all credit markets: municipals, investment credit, high yield and emerging markets.

Rush to cash is throwing markets out of whack

How does this happen? In simple terms, fear of the unknown—the scope of this outbreak and the potential economic fallout—has investors foregoing almost every asset class except cash and very short-term Treasury securities. Leverage is implicit to the way Wall Street works and this rush by investors to exit, i.e., sell positions, in most asset classes is throwing this process all out of whack. For example, a primary dealer typically puts little to no money down to take a position in Treasuries—perhaps 0.02 to 0.025 cents on the dollar to take a position worth millions of 10-year Treasury notes. The remaining $9.8 million is borrowed, using the Treasuries that were purchased as collateral against the loan.

In normal times with a positively sloped yield curve, this level of leverage is manageable. But in times of high market volatility, leverage exacerbates uncertainty and dealers begin to worry about counterparty risk and their market-making capabilities, causing the price-gap between the bid (what the buyer will pay) and ask (what the seller will accept) to widen. For example, in normal times, the 10-year Treasury would trade at a 32 bid/ask ratio with a size of $100-200 million. Now, that bid/ask has been doubled and the size reduced to $50 million. When dealers widen their bid/asks in Treasuries, that cascades to all the other credit markets that are priced off the Treasury curve. This is because credit traders often use Treasuries to hedge their exposure, so if bid/asks are widened and volumes are reduced, the credit markets widen and lose liquidity.

To fully understand the market’s dysfunction, you have to combine this illiquidity with Wall Street’s move toward working remotely. In a normal environment, traders have immediate access to their colleagues’ insights into the relative value of securities and their opinions of what’s happening in the marketplace, as well as their operations teams for trade settlement. It is much different to make markets, take risks and work remotely. Add exchange-traded fund flows into the mix, and you have something of a perfect storm.