Bank of Canada Governor Stephen Poloz takes part in a news conference in Ottawa December 15, 2015.BLAIR GABLE/Reuters
Canada's central bank finally weighed in on the hottest debate in fixed-income markets, concluding that government bond liquidity isn't the terrifying problem it has been made out to be – at least not yet.
For months, a growing number of fixed-income investors and investment banks have warned that new financial system regulations are making it much tougher to trade bonds. There are many different reasons, but they are mostly rooted in one argument: It has become too costly to trade the way people did before.
At first, it seemed that these worries were being voiced only by loudmouthed complainers, particularly those who are anti-regulation by nature, but the debate has raged on and influential voices are now weighing in. Goldman Sachs and the Federal Reserve Bank of New York have recently conducted studies on the alleged problem.
In its latest financial system review, released Tuesday, the Bank of Canada also weighed in, using data to conclude the fear-mongering is likely blown out of proportion. However, the bank's Governor, Stephen Poloz, left a window open by acknowledging that serious problems might emerge the next time there is a full-blown crisis.
Summarizing the complaints, the Bank of Canada noted that many people in bond markets believe new balance sheet constraints restrict trading, and that that eventually leads to lower and more uncertain liquidity. One of the most commonly cited events in support of this view is the "flash rally" in U.S. Treasury markets in October, 2014, and the "bund tantrum" in April of this year.
The central bank takes these worries very seriously, noting "a sudden decline in market liquidity could exacerbate price changes and increase volatility, especially if many investors tried to unwind their positions in the same manner at the same time." In other words, panic could ensue.
But to verify the argument for Government of Canada securities, the central bank study considered multiple variables, including: trade execution costs, including the bid-ask spreads; market depth, or the market's ability to absorb large purchases and sales without major effects on bond prices; and the range of prices of government bonds with the same characteristics – as the Bank of Canada noted, "under perfect market conditions, securities with identical cash flows should have identical prices."
"Over all, these proxies provide little evidence of significant changes in liquidity in recent years," the central bank concluded. "This suggests that the adjustments in market liquidity may be taking place along other dimensions – for example, in terms of the time needed to complete large transactions or the ability of market liquidity to recover after stress events."
The central bank acknowledged market-wide liquidity has deteriorated a bit since the start of the year, but added it "remains well within the range observed in the post-crisis period."
Despite this conclusion, the Bank of Canada did not pour cold water over all concerns. For instance, the financial system review reiterates there are some market peculiarities, such as the increase in government bonds held by buy-and-hold foreign investors, which has reduced the number of bonds available for trading – thereby draining liquidity. The central bank will continue to address those.
In his public remarks Tuesday, Mr. Poloz also cautioned there are no guarantees, no matter how thoroughly the issue is studied, noting "it is proving very difficult to assess the liquidity issue empirically.
"Given the new regulatory architecture, we may not know just how resilient market liquidity is until there's a true stress event," he said.