A former Dallas Federal Reserve Bank adviser has warned that a spike in bond market volatility and recent chaos in the money market could be indicative of a looming credit crisis.

Wall Street’s most watched bond market volatility index spiked in turbulent trading last week, signalling further turbulence in the credit markets.

Credit market volatility, as gauged by the MOVE index, jumped 16 per cent to 89.4. In the same way that a surge in the VIX Index is designed to flag an equity selloff, MOVE suggests there is a risk of a credit event taking place.

“The higher the MOVE index is, the less forgiving markets are to any bit of bad news,” said Danielle DiMartino Booth, chief executive of Quill Intelligence. MOVE hit a three-year high of 91.8 on August 23 and “breaching that high will intensify traders’ anxiety.”

DiMartino Booth, who was an adviser to the Dallas Fed between 2006 and 2015, warned that with the second quarter earnings season fast approaching, the number of opportunities for bad news for any company exposed to the trade war, for example, grows exponentially. She said a second downgrade to General Electric’s debt last year triggered a record 41-day freeze in high yield bond issuance.

The high-profile Wall Street commentator has long been vocal about containing credit volatility after massive growth in triple-b bonds. “You’re talking about a US$250 trillion global debt market, so the Fed must keep the credit market volatility genie inside of the bottle at all costs,” she said.

The surge in MOVE’s volatility last week followed weaker-than-expected job numbers and a sharp decline in US manufacturing activity.

Liquidity drought

Lately market participants have been clamouring for liquidity in the system, suggesting that the financial system may be entering a drought. DiMartino Booth said the market is alluding to the massive delta that followed the third round of US bond purchases, or QE3.

Back then reserves in the system were north of US$2.5 trillion – they’ve since halved. “A 50 per cent reduction in anything is a big deal, but for money markets it’s huge and showing up as spikes in repo and other short-term interest rates.”

Chaos in the money market last month forced the US Federal Reserve to inject US$100 billion into the repo market after short-term rates spiked to almost 10 per cent.

“The Fed was forced to step in to prevent contagion,” she said. “If the Fed had not intervened to relieve the overnight liquidity problem, it would have quickly spilled into other areas of the financial system and thereby have the potential to trigger a separate credit event.”

While it looks to DiMartino Booth as though there is not enough liquidity in the system to satisfy what is needed on an overnight basis, she said it’s important to understand that it’s not QE until the central bank purchases securities to hold on its balance sheet.

“That’s why the Fed is taking such pains to say it’s simply dealing with technical glitch – simply taking the stress out of the system,” she said. “Until there is a credit event, the Fed can say it’s merely adjusting the mechanics of the overnight and/or short-term repo operations of the country.”

If the repo market stabilises relatively quickly, further easing by the Fed will be delayed for now, according to DiMartino Booth. But she says that “all bets are off if repo stays mired in dysfunctionality” until the Fed meeting in October.

“If disruption continues to rule the trading day, the Fed would likely be forced to make a destabilizing intra-FOMC intervention,” she said.

Explanations for liquidity drying up in September range from quarter-end funding needs to post-financial crisis regulation of bank reserves. DiMartino Booth pointed out that eight of the biggest US banks are being penalised for putting new loans on their balance sheets, including short-term repo backed by Treasury.

“You can’t do this to banks – you can’t squeeze the pool of collateral they can hold and still expect them to be liquidity providers in times of need,” the former Fed advisor said.

She said with corporate bond volumes on dealer balance sheets down 90 per cent since the crisis, a standing repo facility would remove that limitation – effectively offering banks overnight QE on demand.

She also argued that the Federal Reserve Bank of New York’s move to transition away from using LIBOR benchmark to SOFR “couldn’t happen at a worse time.” She said SOFR is tied to repo rates, pointing out that the scandal-ridden LIBOR rate behaved last week better than SOFR.

“You can’t have an overnight lending rate that spikes to 8 or 10 per cent,” she said. “There is no functionality about it and that’s the least understood aspect of the overnight liquidity event which we know will get worse since year end squeezes are tighter than they are at quarter year.”

Elizabeth Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
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