The Bond Market Appears Fragile, But Not As Bad As Stocks
In a piece on Bloomberg News, Lisa Abramowicz notes some interesting action in the bond markets after Bill Gross' sudden departure from Pimco to join Janus Capital. Apparently, traders wanted out of some of Gross' largest positions on the fear Pimco's new managers would change strategies. Because Pimco is so huge, any moves by their large funds can move market prices significantly. However, the really important information was found in the middle of the story.
The U.S. bond market is worth about $42 trillion. Abramowicz is concerned because the daily volume traded in the bond market has dropped from over $1 trillion per day in 2008 to about $800 billion daily in 2013. Thus, if the bond market starts to drop, the lower liquidity might make exits tricky. That means there is more risk than investors think in their bond portfolios.
However, a comparison might put bond investors somewhat at ease, although only at the expense of stock investors. The total value of all U.S. stocks is about half the size of the bond market, with the total market cap at about $20.8 trillion. Yet, total daily volume in stocks appears to be less than $200 billion. This is a bit tricky, but NYSE and Nasdaq do report dollar values if you dig enough and their numbers give daily totals of $90-130 billion. Other exchanges surely add to the total (BATS, for example, appears to be about $10 billion daily), which is why I must guess a little.
However, this means that while the bond market is trading about 2 percent of its market cap daily, the stock market is only trading about 1 percent. That means if the bond market is illiquid, the stock market is twice as bad.
I am by no means certain that this is a worrying sign. It is true that the daily volume in dollar terms in both the stock and bond markets has been declining relative to total market caps. However, market liquidity would be best measured by how much could be sold, not how much is sold. There may be more buyers waiting in the wings for lower prices; if prices begin to drop so that selling volume rises, buyers may be ready and willing to purchase at those more favorable prices.
In that regard, the amount of cash on the sidelines is an important factor. Global investors are holding considerably more cash than usual (trillions of dollars worth). This extra cash means there is more liquidity than can be discerned simply from daily trading volumes.
Experts disagree on whether the stock market is overpriced or not, although it is hard to find anybody who thinks the stock market is undervalued. The bond market is somewhat different as almost everybody expects interest rates to slowly rise as the Fed begins to tighten. That means that bond prices are expected to fall. Because of this, bond owners are likely somewhat more nervous than shareholders about the ease with which they can exit the market.
While the daily trading volume of bonds is smaller than it used to be relative to the total value of bonds, that does not mean liquidity is in short supply. It is just as plausible that trading volume is down because everyone who wants to be in bonds is in and not many people want to get out yet. Further, daily trading volumes are a less accurate measure of liquidity than they used to be because investors have more cash on the sidelines.
The decline in trading volume relative to market cap is a cautionary sign. However, if adjusted for cash holdings, there is likely plenty of liquidity to be had when needed. Given the Fed's manipulation of the markets, any investor has plenty of reasons to be careful and nervous. On the list of reasons why stock and bond markets could experience considerable turmoil in the near future liquidity as measured by daily trading volume relative to market cap is way down near the bottom.
