FXStreet (Delhi) – Ralph Axel, Rates Strategist at BofAML, notes that the biggest problem with low liquidity in rates market, in our view, is that markets are less capable of smoothly handling shocks that involve large transfers of risk among investors. Key Quotes “This potentially leads to big overshoots, and suboptimal pricing likely leads to suboptimal economic performance. The biggest recent shock was the China devaluation in August. While we do not know what the “right” market response should have been, the fact that the S&P Index fell 11% in a week then fully recovered may indicate the market response was overdone. The move in swap spreads or TIPS breakevens or off-the-run Treasuries or corporate spreads may turn out to be overdone as well, but the jury is still out on those.” “The Fed tightening cycle is well advertised to be slow and data dependent, and we expect it to turn out that way. But what if the Fed needs to pick up the pace because inflation starts picking up again? Alternatively, if corporate supply pushes rates higher, and improving macro fundamentals also push rates higher, could we see an overshoot in rates and tightening of financial conditions that causes the Fed to go back into hibernation? Or what if corporate or EM mutual funds start to see a prolonged redemption wave and need to sell a lot of illiquid bond assets? Or what if currency wars lead to even greater selling of Treasuries out of foreign exchange reserve accounts?” “We cannot envision all the possible shocks that will inevitably come, and we certainly do not forecast any of these things in our base cases. But even our base case scenario of deteriorating liquidity combined with high corporate supply and ongoing M&A deals, and what is likely to be a Fed tightening cycle in 2016 seems to set the stage for a market that is very vulnerable to gapping spread and rate moves and other dislocations. It is obvious Dodd-Frank regulations resulted in much better capitalized financial institutions better able to withstand limited access to funding markets in times of stress. But if market dislocations are twice as large when the shock comes and capital levels are twice as high, is the system really any safer? An illiquidity trap may turn out to be just as problematic as the dreaded liquidity trap.” For more information, read our latest forex news.