Is Dodd Frank yet another example of regulation that has created the next crisis? Dodd Frank changed the landscape in which the fixed income market operates, a market that is about 10 times greater in size and importance than the equity market.
When I came into the industry after graduating from college almost thirty years ago, a fixed income sales trader was the job. In 1993, President Clinton’s aid George Stephonopoulos coined the term “It’s the bond market stupid” following a terse discussion with the President as to why certain policies could not be pursued.
The size of the US bond market has ballooned by more than $5 trillion since 2008 to $37.8 trillion at year end. Trading however according to the regulatory authority SIFMA fell to average daily turnover rate of $809 billion from $1.04 trillion in 2008.
This decline in volume is largely attributed to Dodd Frank’s strangling regulations which have mandated higher capital requirements to trade debt, capital requirements that differ based upon the size, the trading volume and quality of the debt outstanding.
Largely because of these higher capital requirements, Primary Dealers (mega capitalized banks) slashed the amount of bonds they hold by 76% from a record high of $56 billion reached October 2007.
According to Barclays, turnover in investment grade corporate bonds fell to a 72% annualized rate during the first half of this year, the least in the past decade.
Why does this matter? Capital (aka debt formation) and liquidity is paramount for the economy and the markets.
The regulatory entities have attempted to “equify” fixed income trading. This is impossible to accomplish given that many companies have several bond issuances outstanding, each differing in security within the capital structure. Stocks on the other hand only have on common equity issuance outstanding.
The past month many fixed income positions have been crushed, declines anywhere between 5% and 12%, the result of illiquidity and fears of a change in monetary policy.
In other words, just as the Fed is about to withdraw stimulus and liquidity is essential, the regulatory authorities have made it very difficult for the banks to be willing and be able to take risks.
I can clearly envision a scenario that liquidity will be virtually nonexistent for many issuances just when the proverbial stuff hit the fan thus causing greater prices declines than normal.
As noted above, the last four weeks have been ugly for many aspects of the bond market with just the talk of a change in monetary policy.
I reiterate what will happen when change does occur? It could be ugly given the dearth of sales traders and the rules that discourage risk based trading to provide an orderly market.
Commenting upon yesterday’s activity, equities sold off as Hong Kong added to geopolitical uncertainty and the Ukrainian army suffered its worst losses since the commencement of the cease fire.
Some have stated the selloff was also predicated by stronger than expected data that perhaps suggested a change in monetary policy will come sooner rather than later. Treasuries however gained in price, perhaps the result of a “flight to quality” because of geopolitical tensions.
What will happen today? A regional manufacturing diffusion index and a home price index are released.
Last night the foreign markets were mixed. London was down 0.01%, Paris up 1.30% and Frankfurt up 0.55%. Japan was down 0.84%and Hang Sang down 1.28%.
The Dow should open nominally higher as all are contemplating the economic, interest rate and geopolitical environment. The 10-year is off 8/32 to yield 2.51%.
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