Over the last few months, more aggressive monetary tightening, especially in the US, has led a steep sell-off in public debt markets, resulting in unprecedented interest rate volatility. Market fractures have started to appear, such as the recent turmoil in the UK Gilt market, as funding becomes expensive and scarce. The combined effect of high volatility and funding costs, amplified by leverage and concentration risk, could set off a so-called “liquidity spiral”—funding needs triggered by falling prices increase demand for safe collateral to cover margin calls and shore up liquidity buffers.
Liquidity squeezes increase valuation risk for less liquid assets, such as corporate bonds, which are coming under increasing scrutiny due to a deteriorating economic outlook. Since the trading of corporate bonds relies heavily on intermediation, liquidity constraints could complicate market-making and negatively impact the valuation of corporate credit. We find that the current risk in liquidity risk accounts for ~10-30bps and ~30-60bps of the total year-over-year spread widening of IG and HY corporate bond in the US and Europe, respectively. This is a worrying development given that corporate credit, especially investment grade (IG), is having one of the worst years in recorded history. However, we expect corporate markets to gradually regain stability and liquidity on the back of a policy pivot in 2023 and a more stable long-end of yield curves.
While the implementation of monetary policy operates mostly through the government bond market, corporate bonds could benefit from an overall improvement in market liquidity. Central banks can help address the adverse impact of the current pace of monetary tightening on market functioning – or “plumbing” – by making securities lending more widely accessible at lower cost could address current collateral scarcity. Widening collateral eligibility for accessing central bank money could also boost precious liquidity in corners of the capital market that are at risk of liquidity squeezes, such as corporate debt.