Friday, 6 March 2009

Holding Treasury Bonds - 30 Years or 30 seconds

The following sentence from a financial blog goes right to the heart of the financial leverage party which is now ending.

"We developed too many speculators in the 2000s, and not enough parties that would hold assets to maturity."

Price discovery takes place at the margins - for example a 30 year bond is priced on a tick by tick basis in Chicago pits by traders that may be holding a T Bond futures contract for 30 seconds not 30 years. There is nothing inherently wrong with such a speculative mechanism.
The problem arises when one uses price discovery at the margin as the valuation cornerstone for an entire portfolio, either long or short, ratcheted up with massive leverage.
We may have a safer financial system as leverage ratios come down to much reduced levels but when more institutions are holding assets, if not to maturity then for much longer periods with far less short term rolling over of positions, the level of activity in the capital markets will decline quite significantly. In turn, this will lead to less market liquidity which sets up a self reinforcing trend for much less financial intermediation.
In the previous era of fast hot money every time capital moved lots of people were able to skim a bit here and a bit there but when, as is to be expected in the coming years, less of it will be moving and when it does move it will do so with less frequency, there is a radically different outlook for earnings possibilities throughout the financial services sector.

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