By Jonathan Spicer and Michael Flaherty
NEW YORK/WASHINGTON (Reuters) - While Wall Street frets over the ability of bond markets to absorb an approaching interest rate rise, the U.S. Federal Reserve has a message for the industry: deal with it.
The financial industry worries that when the Fed's tightening plans take hold, a sell-off in the massive U.S. bond market could ensue, and be exacerbated by a lack of bank buyers willing to jump in.
Banks, including primary dealers who act as market makers for U.S. Treasuries, have slashed bond inventories in the past few years in response to tougher capital requirements, reducing a liquidity buffer for the fixed income market.
Private and public comments by Fed officials show that they do not share Wall Street's degree of concern about liquidity, and do not believe that capital rules are solely to blame for the bond market's growing tendency to seize up.
Effectively, regulators are telling the industry it is the responsibility of banks, funds and other market players to protect themselves.
"It's hard to find any financial market player who doesn't talk about being concerned about potential liquidity issues," Eric Rosengren, president of the Boston Fed, which oversees many of the country's largest asset managers, told Reuters.
"So it would surprise me if I found that people were using a particular model and didn't use any intuition about what goes into those models, and what might happen if everybody blindly uses those models."
At last week's congressional hearings, Fed Chair Janet Yellen resisted pressure by Republicans to acknowledge that new capital rules were destabilizing markets.
"You see this decline in liquidity in some measures, but not others," she told senators on Thursday.
The Fed's assertive stance is setting the stage for more volatile fixed income markets and where liquidity droughts could be the price of doing business in bond markets.
The message - in public addresses, reports to Congress, and even an investigation into market turmoil last October - is that less liquidity is a necessary consequence of regulatory reform and fitting for an economy that is getting ready for tighter monetary policy.
Investors cite many causes of market vulnerability: primary dealers holding far fewer bonds and the Fed holding far more; bans on some broker proprietary trading; a growing reliance on high-frequency trading; worries that funds will not have enough assets to withstand a firesale by clients; and rising volatility, especially in the emerging markets that could see big selloffs when the Fed hikes rates.
Overall U.S. bond market volatility has risen 60 percent since a mid-2014 low, according to Bank of America Merrill Lynch's MOVE index, which measures the implied volatility of U.S. Treasury markets - a statistic that underscores liquidity concerns.
BlackRock, the world's largest asset manager, has suggested it was time to move on and start devising strategies on trading through the dry patches rather than keep pushing back against tougher regulation.
ROUGHER SEAS
"There's plenty of capital there. We need to talk about how that needs to move from holder to holder," Richard Prager, BlackRock's global head of trading and capital markets told a financial forum in May. "We clearly have a liquidity challenge at the moment but we have to recognize the journey and talk about what needs to be done."
Three Fed governors have recently downplayed regulators' role on the new dynamic taking over the bond market.
On July 15, the Fed reiterated that stance in its bi-annual monetary policy report to Congress, when the central bank said it did not see significant deterioration of liquidity in either the Treasury or the corporate bond market.
U.S. Treasuries are the easiest debt security to trade globally, with the spread between bid and ask prices less than a hundredth of a percent.
But for 12 minutes on Oct. 15, sellers backed away, causing a wild price swing that sent the yield on the 10-year Treasury up by 0.16 percent and then down again.
In a report on the incident published last week, the Fed and other regulators found no single cause, while pledging to review firms' risk-management strategies and monitor liquidity in the market.
What the Fed seems to be telling money managers is that they should be aware of a possibility of panic selling and a lack of buyers if all of them following similar risk models.
"I think they want to know that we are thinking about it and addressing it and I think now we all are," an executive at an asset management firm, who requested anonymity.
(Reporting by Jonathan Spicer and Michael Flaherty; additional reporting by Jessica Toonkel in New York; Editing by Tomasz Janowski)
