A Tale of Two Liquidity Measures

The story of financial markets in the past twelve months has not been one of organic growth. It has
been a central bank accommodated liquidity story. This melt up will end in melt down when
unsustainable liquidity policy is insufficient to address deleveraging and default. Macro trade
positioning needs functional measures of liquidity. As has been said before, liquidity will always be
around until you need it.

Given the explosion of financial product innovation, international capital flows, and leverage some
measures of liquidity are not as informative as they once were. New ones are needed. Further, thinking
through liquidity phenomena to their essence is really about understanding connections to market-
maker and/or seller distress, manifested in the bid-ask. So measures that exhibit a myopic view on
credit risk of market players in some ways serve as a function liquidity measures.

There is a clean measure of credit risk in CDS spreads, but they have some problems of price discovery.
Also a comprehensive liquidity measure should be macro-environmental in scope. Time to think outside
the box: a possible direction is to apply tools (the concept of basis factors) from bonds to interest rate
swaps. I’ll be speaking the swapish dialect, meaning the rate is the price, not the asset value. So a
higher swap rate = win, whereas in bonds a higher yield means lower asset value.

Let’s first look at an old-school metric of system-wide liquidity.

Commercial Paper to T-Bill Spread

During the credit crunches of the 60s and 70s, this spread always saw significant rises. Consequently, it
was a good predictor of GDP as well, in a statistical sense. The chart below is the spread between 1
month financial commercial paper over 1month t-bills.

The Mechanism

 This spread is the difference between a risky rate (specific to financials) and a reference rate. In
this sense, it is a measure of aggregate credit risk measured over a short duration.

 It captures the stance of monetary policy relative to bank liquidity needs. If monetary policy is
tight, this raises the cost of funds to banks. To compensate, they can issue CDs, raise interest
rates on deposits, sell treasury securities, or reduce lending. Note that the correlation of
commercial paper rates and certificate of deposit rates is 0.98 from 2000 to 2010. CDs and
higher deposit rates would compete with commercial paper, raising the spread. Reducing
lending would result in higher commercial paper issuance to compensate, raising the spread.
Banks selling t-bills in the presence of tight money doesn’t often happen.
So this spread combines information about monetary (money market/financing conditions) and non-
monetary factors (credit risk). Currently, these spreads are well below the 2000-2010 average (there is
no effective way to distinguish nominal and real given CPI is such a joke). The implication is that
monetary policy is very accommodating at present. So why is Bernanke so hot on the “extended period”
verbiage?
 Basic Statistical Measures: Financial Commercial Paper Spreads over T-Bills
(One Month)
Current (4/26/2010) 0.1 Std Deviation 0.46201
Mean 0.362745 Variance 0.21346
Median 0.180000 Range 4.13000
Mode 0.060000 Inter-quartile Range 0.32000

Well, because in an era of hundred-trillion dollar derivative exposures, commercial paper and real
economic activity doesn’t really matter so much in the grand scheme. What matters instead is the over-
arching financial structure that functions as a return generating liquidity sponge. Its phenomenal
growth (not necessarily by explicit design) is due to the need to absorb uber-accomodative monetary
policy and out of control leveraging. In effect, it inhibits the physical delivery of liquidity into the
underlying economy while at the same time allowing the gamblers at the black jack table to double
down until they finally win. The former function is desirable, because physical delivery means inflation.
The latter will end in the casino’s ruin.

However, I theorize that the liquidity absorption works too well when the internal core of the financial
system is itself insolvent—now a great deal larger than the aggregated liquidity needs of firms,
households, and investors. Then the derivative structures no longer inhibit the physical delivery of
liquidity. Rather, they become a draw on any existing liquidity and cause dramatic problems, like a
combustion engine without lubrication. This is because enormous relative size implies relatively
enormous liquidity needs.

Before it collapses in on itself, it draws liquidity from all possible sources. As with all things, the system
seems to work well enough until its existential conditions change. Then it is suddenly unfit for survival…
and doesn’t. This is the bitter nature of “too big too fail” even though liquidity looks fine on the surface.
The only things that have saving power are nominal growth either through quantitative easing directly
into the financial system or organic growth that leads to credit growth. So we need a measure that
reflects the nature of the system.

A Cash-Synthetic Liquidity Measure

Perhaps there is more to the “it’s all supply and demand” explanation for negative swap spread on 30s
and (before arb kicked in) 10s than meets the eye. Especially when the demand and supply considered
is of the cash-synthetic variety.

The interest rate swap spread is not a spread like the cash-CDS basis, but the tools of negative and
positive basis can be applied to it. The differences are that CDS is essentially a view on credit risk of the
underlying cash instrument. The credit risk embedded in IRS and treasuries is negligible. Further, IRS
swaps are an asset class in and of themselves. They do not embody an intrinsic view on, nor are they
intrinsically connected to treasuries.

However, in their function interest rate swaps serve as substitutes for treasuries. IRS and treasuries are
yield-generating way to move duration. Nothing else comes close in terms of the ability to absorb
liquidity with miniscule transactions costs. Further, explicit government guarantees and backstops on
one hand and required primary dealer bidding on treasury auctions effectively join primary dealers and
the state at the hip. The credit risk of one becomes equal to the credit risk of the other. More
importantly, there is an arbitrage relationship between the treasuries and same-maturity IRS that tie
them together.

The analogy only goes so far, and the point is that the swap spread is amenable to the tools from cash-
synthetic basis trading, albeit on a pretty unique “riskless” reference entity. In this light, the strange
case of a negative swap spread is nothing more than negative cash-synthetic basis, using the language of
bond dudes. The fundamental question then becomes whether or not there is a fundamental mispricing
of treasuries, or other factors are driving what is going on.

Basis trading catalogs a number of such factors, but these don’t all apply to a cash instrument like
treasuries. It’s possible to arrive at the factors that do impact the defined basis. In turn, these factors
are indicative of the liquidity conditions of the financial system.

The Mechanism

 Treasuries trading below par (more positive basis): the cheaper the cash instrument, the less
the need for a substitute.

 Hedging activity (more negative basis): swaps are capital efficient hedging tools. You can move
huge amounts of duration and not lock up capital in treasuries.
 Counterparty Risk (not an issue here): this is a non-issue for the described basis. The
collateral/margining/novation structures and government backstops/explicit guarantees mean
that credit risk embedded in cash synthetic is miniscule and equal.
  Liquidity Conditions (more negative basis): it requires more cash spread to hold a bond position
as opposed to an interest rate swap, because of the capital efficiency of the swap. When
liquidity is tight, this drives the basis negative.

 Relative Liquidity (more negative basis): the liquidity of treasuries and swap markets are
different, but this is much less an issue as found in other markets. However, at durations past
mid-curve, this could make for a significantly more negative basis.
 Cash supply (more negative basis): supply is driven by borrower issuance, not swap issuance.
Unrelieved and heavy treasury supply with no end in sight.
 Repo optionality (more positive basis): When treasuries go special it generates a positive basis.
And if the demand for the cash treasury outstrips supply, the cash investor has a repo
optionality that is not embedded in the swap.
The laboratory: the most liquid cash instrument available is the 5Y treasury. It’s no coincidence that
the most liquid derivative instrument around is the 5Y swap.

The swap spread is now at fundamental lows, but the issue is not a negative basis. The big deal is the
basis tightening and widening at this duration. What drives the cash-synthetic basis here is ambiguous.
Repo optionality appears to be an important issue during times of shocks. The basis hit its high (in this
chart) on October 3, 2008, dropped all through November, December and January, then spiked March
18, 2009 (about when AIG became a zombie).

Inflation causes treasuries to trade below par, and distressed cash instrument values did drive the basis
wider in mid-2006, 2007. In late-2008 and following (less a few repo-optionality generated shocks) the
basis tightened.
The explanation to the tightening basis here is the illiquidity of the financial system. It indicates
illiquidity primarily because in this context illiquidity is an unwillingness to lock up capital in a cash
instrument when more capital-efficient return vehicles exist, even if the return on cash is superior.
Secondly, system Illiquidity is also connected to treasury supply, just as cash supply is a driver in any
cash-synthetic basis.

It is unclear which factor (cash supply or capital efficiency) dominates but they both imply liquidity
problems for the global financial system. Indeed, fully negative swap spreads are already seen just this
year at long durations. If memory serves, swap spreads briefly went negative even in the mid-curve (7Y)
this year.

Treasury supply is absolutely unprecedented (see below—not for the weak of heart), and it implies a
stop-gap measure to fill the implosion of private sector credit and tax revenues. The U.S. economy is
incredibly sick. This is precisely the context where liquidity vanishes when you need it most.

Treasury
(in billions)
2000 312.4 Theoretically am arbitrary cash-synthetic basis
2001 380.7 mean-reverts to zero, but the described
2002 571.6 relationship is only an analogy. And all theory,
2003 745.2 even mean-reversion itself, is inherently
2004 853.3 unstable. Any true mean-reversion implies the
2005 746.2 end of Greenspan put. It also implies a
2006 788.5 reduction in treasury issuance. When the
2007 752.3 financial system is again exposed to market
2008 1,037.3 forces without protective redistribution policies
2009 2,097.7 and treasury issuance is reduced, this basis
Source: SIFMA construction as conceived will widen
considerably.