The Effect of Illiquidity

forex, market liquidity, illiquidity, euro yen, EURJPY, EURJPY, Bank of Japan

13 May 2015

Recent volatility in sovereign yields should give the trader pause to reconsider ‘crowded trades’.

Both Japan and the EU are still fully engaged in unprecedented stimulus programs. Private sector investors in Japan have also been on a bond buying tear. Most notably, Japanese life insurance companies are scrambling for the relatively higher yields of US Treasuries. As reported in the Wall Street Journal, 26 April, Toshihiko Yamashita, of Meiji Yasuda Life Insurance Co., stated: “We’ll be aggressively increasing our holdings ... Considering current yield levels, liquidity, hedging of currency exposure, the U.S. is likely the primary destination”. Meiji Life plans to purchase more than one trillion Yen, which translates to over $8 billion US dollars. Over the two weeks since Meiji disclosed their strategy, advanced economy sovereigns yields have spiked making US Yields all the more attractive. The reason for this is simple. Insurance companies, anywhere, prefer to payout on policies with the local currency, thus avoiding currency risk. However, slow growth and QE bond buying programs the world over, are making it difficult for the life insurers to produce returns for investors.  Some companies are looking for yield beyond U.S. Treasuries. For example, Asahi Mutual has been purchasing Japanese private sector dollar denominated bonds. Most interesting is that these dollar denominated bonds are offering better yields than equivalent Yen denominated bonds. Fukoku Mutual, Asahi Mutual and Sumitomo Life are pursuing similar sovereign fixed income bond purchases or dollar denominated bond strategies to the tune of nearly one trillion Yen, or about $8 billion USD.

Another problem forcing rates low and driving Japanese investors out of Yen is the low liquidity of JGBs. On 23 April, Makoto Yamashita, strategist at Deutsche Securities Inc. noted that “The market’s liquidity is thin, so even a little buying by the BOJ will cause yields to move easily... There are a lot of investors who haven’t bought enough bonds since the start of Japan’s fiscal year this month, according to Yamashita”.

Insurers in the Eurozone are facing a parallel problem. Richard McGuire, head of European rates strategy at Rabobank stated, “It’s very easy to enter the market but difficult to get out when liquidity is thin ... Investors go in through the door, but in a selloff they have to come out through a keyhole”. The capital outflow problem is not restricted to those nations with negative yielding government bonds. Over the past several months, China has seen record capital outflows. When the dollar strengthened and the Euro fell by nearly 11% in the first quarter, the PBOC was forced to purchase Yuan to offset depreciation in the dollar value of its reserves.