A couple of global media reports are keying in on an interesting modern trend: As governments undertake unprecedented monetary actions o keep the global economy growing the actions are crowding bond traders in the secondary market.
The issue has become notable in Japan where the government is now the central player in bond markets. Bond-market volume for some maturities has fallen by a third in the past year. According to recent reports the benchmark note is not even trading for long stretches—recently it was midday on two recent trading days before a single Japanese government bond traded. "Liquidity is becoming a serious issue," said a bond trader was quoted as saying.
The shift reflects an unintended of the current reality that sees central banks creating and buying debt to restore demand in economies crippled by the financial crisis. In the case of the Bank of Japan, the central bank is undertaking unprecedented asset purchase program that has created a "creeping paralysis" in the secondary market where traders typically buy and sell bonds. Because investors, primary dealers, know they can buy bonds from the Bank of Japan and then sell them back to the central bank a little later at more expensive prices there is no point to trading in the secondary market. The result, liquidity in the traditional secondary market is drying up.
"Investors in Japan assume that the BOJ will continue to buy JGBs vigilantly next year and the year after," Makoto Yamashita, the chief Japan rate strategist at Deutsche Securities, was quoted as saying. "They take it for granted they can sell those bonds bought expensively to the BOJ as more and more notes disappear from the secondary market. It's too frightening to think what might happen when the BOJ tapers."
Eventually, if the BOJ begins to taper the amount of bond buying some worry they will be stuck with inventories of un-tradable bonds. The worry is that when investors try to exit their positions, “there may be some kind of squeeze."
No wonder then that as trading has slumped the notional value of over-the-counter derivatives sold to hedge these risks has soared fivefold in the past decade. According to a recent report citing data from the Bank for International Settlements the value of outstanding derivatives is now $710 trillion.