The calm on global financial markets masks a growing threat to their smooth functioning should shrinking liquidity morph into an outright crunch in response to a U.S. interest rate rise or some other shock.
The price of German 10-year government bonds plunged this week, triggering the biggest rise in yield in over two years. Some analysts blamed the sell-off on a lack of liquidity, with Commerzbank going so far as to call it a "flash crash".
There was no discernible market instability like a widening of bid/offer spreads, often a reliable sign of thinning liquidity. But there have been signs of potential dislocation in recent weeks -- on one day in March the Bund bid-offer spread blew out to nearly 6 basis points, the widest in three years.
Analysis from GreySpark Partners shows that the average spread in high grade U.S. corporate bonds since 2011 is around 12 basis points. In the five years before the global financial crisis, it was 7 basis points.
As long as asset prices are rising, as most are thanks to super-easy global monetary policy, this isn't a problem. But it will be if there is a sudden reversal and traders are forced to offload assets only to discover there are no buyers.
"This is a critical problem to the functioning of markets," said Andy Hill, director of market practice and regulatory policy at the International Capital Market Association.
"Without secondary market liquidity, primary issuance will be impaired. We're in a fragile state now," he said, adding that lower rated corporate bonds, high yield debt and emerging markets are most vulnerable to a crunch.
The potential for a sudden freeze across a range of markets is a growing source of concern and debate among global policymakers and regulators.
They are trying to assess the impact on markets of regulatory changes that force banks to hold more capital and less inventory on their books. Financial market participants say this is curbing banks' trading and their ability to act as market-makers in many fixed income, currency and money markets.
CARRY ON SHRINKING
There's an important difference between the sea of liquidity worth trillions of dollars provided by global central banks in recent years and the dwindling liquidity as measured by market trading. In some ways, they are two sides of the same coin.
The former is self-evident. As the Bank for International Settlements said in a recent report, global liquidity is "abundant".
Central banks have printed $11 trillion since 2007, bringing central bank liquidity coursing through the global financial system to more than $16 trillion, according to Deutsche Bank. The European Central Bank is in the process of adding a further $1 trillion and China may act too.
But the latter, essentially a measure of the cost and ease of transacting a particular asset without prompting a huge swing in its price, is much less visible and harder to quantify.
This parallel trend of rising cash liquidity from central bank largesse and shrinking market liquidity was outlined in two recent investment bank reports.
In 2005 the U.S. corporate credit asset universe was worth around $9 trillion, of which 5 percent was on dealers' inventories. These assets are now worth around $12 trillion, of which less than 1 percent is on dealers' inventories.
"Shrinking dealer balance sheets coupled with bond market growth have led to a significant worsening of fixed income liquidity, especially in corporate bonds," Morgan Stanley said.
Primary dealers now hold only around $50 billion of U.S. corporate bonds on their books compared with $300 billion before the crisis, according to a study by Deutsche Bank.
In that time the total stock of outstanding bonds has more than doubled to $4.5 trillion from just under $2 trillion. Lower inventory means dealers will be less able to match wary buyers with panicked sellers and smooth out any market volatility.
Factoring in all markets -- interest rates and repo, currencies, emerging markets and commodities, credit and equities -- Morgan Stanley calculates that banks' balance sheets shrank by around 20 percent last year and will shrink a further 10-15 percent over the next two years.
The most obvious shock to markets on the horizon is the U.S. Federal Reserve's rate hike. When it comes, it will be the first rise in U.S. interest rates since June 2006. Simply put, there are many traders who have no experience of the world's most important interest rate going up.