Quality is king in a liquidity squeeze Quality is king in a liquidity squeeze Quality is king in a liquidity squeeze

Quality is king in a liquidity squeeze

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  The sudden issuance of roughly half a trillion dollars' worth of T-bills in four weeks might accelerate a liquidity squeeze. As volatility rises, we stay defensive and favor quality. With bond yields at their highest in more than ten years, bonds look more compelling than stocks. High-quality fixed-income instruments are less volatile and often perform better during a recession than other financial assets.


Soaring short-term interest rates, tightening financial conditions, falling commodity prices, and a strong dollar. These factors might lead markets to the tail event of a liquidity squeeze.

A liquidity crunch materializes when the short-term availability of money decreases. Thus, banks may be reluctant to lend money and increase lending requirements. That's why a large amount of T-Bill issuance coming after the debt-ceiling agreement might be the catalyst for a liquidity squeeze.

How much should I be worried about a liquidity crunch?

The fact that the stock market continues to be complacent doesn't mean that the tail risk of a recession is remote. In times like these, when nobody can envision a crunch, hell breaks loose.

Things are not encouraging, and a liquidity squeeze seems worth hedging against.

(1) The amount of debt the US Treasury must issue by the end of June is not negligible. In only four weeks, the Treasury will need to place the biggest net bill issuance in markets outside of a crisis.

Source: Bloomberg, Cameron Crise.

(2) Although the St. Louis Fed Financial Stress Index remains below zero and well below the March peak, it's notable to see an uptick in the last reading of May 19th. Although minor, that uptick might signal an early sign of a liquidity drain.

Source: Bloomberg.

(3) The implied volatility in US Treasury bonds remains elevated, suggesting that yields might rise further in the foreseeable future, increasing the risk of a liquidity squeeze. Volatility in stock markets remains muted, but the more bond volatility remains elevated, the higher the potential for the VIX to spike.

Source: Bloomberg.

How can I position myself for a downturn?

Yesterday's article discussed how the sudden issuance of roughly half a trillion dollars' worth of T-bills would likely drain liquidity. We looked at the yield curve and how yields could shift in the short term. However, what instruments perform the best during a downturn?

With bond yields at their highest in more than ten years, investors should focus on locking in quality. Bonds are relatively safer than stocks; they are less volatile and often perform better during a recession than other financial assets. That's the reason why, on the below points, we focus on bond instruments:

1. Safe heavens: gold (GC future contract, GOLD:xpar). US dollar. Japanese Yen. 10-year US Treasuries (US91282CHC82, IEF:xnas). In yesterday's article, we discussed the short-term potential for 2-year and 10-year yields to rise. Yet, it is key to understand that while the former is vulnerable to monetary policies, the latter serves as a safe haven. Therefore, 10-year yields can soar in the short term because the market is pricing more Fed hikes while the market is complacent and inflation remains stubborn. It's safe to assume that the central bank will do a U-turn if volatility spikes. Hence, long-term yields will drop in that scenario.  

2. 
Quality. Pick investment grade versus junk. But even within the Investment Grade segment, it's best to avoid the lowest-rated instruments (BBB) as they might suffer from a downgrade. You can also pick shorter or longer duration when searching for high-quality bond ETFs. For example, the iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB:xnas) and the iShares 5-10 Year Investment Grade Corporate Bond ETF (IGIB:xnas) invest only in bonds within that time frame. Please find below an inspirational list

Source: Saxo Group.
3. Stay defensive. Utilities, consumer staples, and healthcare. These sectors maintain their income streams even when the market is volatile. The Invesco Investment Grade Defensive ETF (IIGD: arcs) might provide such exposure to your portfolio.
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