Fed Will Open “Pandora’s Box” With Rate Hike, UBS Warns

On common theme we’ve been building on lately as central banks work to monetize all net (and sometimes gross) government bond issuance in their respective jurisdictions, is that QE is destabilizing markets by sapping liquidity which in turn inhibits price discovery and creates volatility. This is on display in Japan, where 2 out of 3 dealers think the JGB market is impaired thanks to BoJ asset purchases and where many officials are beginning to get more vocal about the possibility that a lack of liquidity could have “dire consequences.” Similarly, market financing via shadow banking conduits has declined by nearly half since 2008 in the US, and with dealers unwilling to hold inventory of corporate paper thanks to tougher capital requirements, the stage is set for what the Center for Financial Stability recently called “an accident.” As a reminder, here’s what  the SEC’s Daniel Gallagher had to say recently about liquidity in the US corporate bond market (via Bloomberg): 

Lack of liquidity in corporate bond market is “systemic risk” not addressed by regulators, SEC Commissioner Daniel Gallagher says in public remarks.

Gallagher cites 80% decline in corporate bond inventories among dealers and impact of higher interest rates on future trading needs; “that has accompanied a record level of issuance year after year since 2008 of $1 trillion-plus of corporate debt”

“I would submit to you that the lack of liquidity in our securities markets is a systemic risk,” he says at conference sponsored by Institute of International Finance.

Today, we get yet another warning about the increasing degree of illiquidity in fixed income markets, this time courtesy of UBS, who warns a Fed rate hike could open a “Pandora’s Box” for corporate credit spreads.

Via UBS:

Pandora’s Box: Fed Tightening Is a Problem for Credit