“Fear And Greed”: Central Bank Front-Running And What It Means For Traders

“Fear and greed [used to be] a continuum, allowing for an ebb and flow with continuous price discovery and availability,” Bloomberg’s Richard Breslow wrote on Thursday. “What we have now is pedal to the metal front-running of central banks and the nagging fear that when the fun ends there won’t be a bid anyway, so why bother being prudent.”

We thought that a rather apt description of today’s markets and a rather timely one at that, given the ECB has just kicked off its foray into corporate bond purchases.

The central bank front-running narrative is an important one when it comes to understanding some of the anomalies that will likely end up rattling global markets with increasing frequency as monetary policy makers persist in their quest to boost growth and juice inflation.

One theme we’ve built on in these pages is that markets are increasingly interconnected. This is just one giant fungible liquidity regime. That’s a fancy way of saying this: US equities traders now need to be aware not only of how movements in FX and commodities markets affect stocks, but must also be cognizant of the fact that going forward, events that used to be confined to dealer desk diatribes will be relevant for everyday traders.

Let’s look at an example of a seemingly esoteric event that illustrates this point.

Back in March, the bid-to-cover on one of the Bank of Japan’s bond buying operations spiked to 3.58 from 2.93 the previous week. Put simply: a lot of people were suddenly looking to offload their Japanese government bonds to the central bank. Yields soared 8 basis points in the selloff, tripping a circuit breaker so that everyone could “calm down.”

(Chart: Bloomberg)

Can you guess what happened the day before? Yields on Japanese 10s collapsed to all-time lows.

What had occurred was simple: investors rushed in to front-run the next day’s Bank of Japan bond buying operation and then, the following day, everyone got spooked when the impetus to unload came in stronger than expected. Cue the selloff.

So why should you care? Because what the above incident makes clear is that the conditions are ripe for completely irrational trading in supposedly highly liquid, highly efficient markets for safe haven securities. Trust us, you do not want Japanese government bonds and German bunds (profiled here earlier) trading like penny stocks overseas while you’re asleep.

And it’s not just irrational trading or frontrunning gone awry. There’s also liquidity to worry about. We know, “bond market liquidity” is so yesterday. But think about it from a different angle than that discussed here on Thursday. That is, think about it from the perspective of how investors might begin to price bonds in markets where central banks have a heavy footprint. Last summer, yields on Swedish 10Y bonds actually rose as the central bank bought because apparently, investors were pricing in a liquidity premium. In other words, the market was saying this: “...you are creating so much of a liquidity risk by cornering the market that we want more yield for our trouble.”

With that in mind, consider what the market is saying about the ECB’s corporate sector purchase program, via BofAML’s monthly credit survey:

“June’s credit survey shows that investors have headed into the start of the ECB’s Corporate Sector Purchase Programme feeling much more downbeat than in April. Investment-grade overweights have been cut by more than 10% since our last survey, with only a net 28% of respondents long the market now.

“Investors remain skeptical towards the purpose and efficacy of CSPP – in fact more so now than in April. Close to 90% of high-grade investors think that corporate QE is concerning, for reasons such as spreads failing to reflect fundamentals, worsening bond liquidity, or the policy having a minimal impact on the Eurozone economic outlook. Only 6% feel encouraged by the fact that that corporate bond QE could tighten spreads (down from 13% in April).”

In other words, investors are rather perturbed about the possibility that the ECB is about to embed the same types of risks into corporate credit markets that already exist in government bond markets. Namely, that spreads won’t reflect actual credit risk and that liquidity will dry up.

If we start getting moves in corporate bonds that mirror what we’ve seen in German bunds, Japanese government bonds, and even in US Treasurys during the October 2014 flash crash, well then things will get truly scary.

Coming full circle we ask: have these worries deterred Breslow’s “pedal to the metal” central bank front-runners? Apparently not:

(Chart: BofAML)