Stocks Aren't the Scariest Financial Market Right Now

By Markets Fool.com


Bonds could become the next crisis point for the market. Image: U.S. Treasury.

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The bull market in stocks has lasted for more than six years now, spurring growing worries among many investors about the potential for a pullback and its impact on the growth of the U.S. economy. The Dow Jones Industrials has declined slightly from its record highs, losing another 46 points Thursday as of 11:30 a.m. EDT and deepening its losses since early March to more than 400 points, but the small-cap Russell 2000 remains much closer to its all-time high. Amid uncertainty about the future of the stock market, it's surprising to discover that an increasing number of market participants are even more concerned about the bond market and the potential for systemic shocks that some believe could lead to a new financial crisis.

Bankers speak out about the bond market
The bond market has never been as friendly to individual investors as has the stock market, with bond trading designed to ensure a flow of transaction-related income to brokers and resisting efforts to increase transparency and ease of trading for nonprofessionals. Yet even among institutional investors, alarm about the current structure of the bond market has grown louder.

JPMorgan Chase CEO Jamie Dimon. Image: Flickr / Steve Jurvetson.

JPMorgan Chase CEO Jamie Dimon has never been hesitant to voice his opinions about financial matters, and he recently pointed to a lack of liquidity in the Treasury market as a potential source of risk for the entire financial market system. In particular, Dimon cited last October's plunge in Treasury yields from 2.20% to 1.86%, with much of the decline and subsequent rebound coming within a roughly 30-minute span. Although a move of about a third of a percentage point might not seem like much, the price changes involved were quite dramatic for a market typically known for stability. Dimon characterized it as happening "once in every 3 billion years or so," and bond traders could only point to a single instance over the past half-century in which bond market volatility was greater -- and that came during the height of the financial crisis in November 2008. Former Treasury Secretary Larry Summers echoed Dimon's sentiment, asserting the need for regulation to deal with a perceived lack of liquidity in the bond market.

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The bond market faces a number of issues that have led to liquidity concerns. On one hand, the Federal Reserve's quantitative easing policies involved direct purchases of longer-term Treasury securities, in some cases dramatically reducing the amount of available bonds for certain maturities. Taking those Treasuries out of the market left traders with less liquid conditions that exacerbated price movements. Moreover, with the relatively small number of companies qualifying to issue corporate debt of the highest quality, those institutions that are only allowed to buy top-rated bonds have less supply to choose from, and that has led to some market inefficiencies as well.

U.S. Treasury. Image: Wikimedia Commons.

Until now, those issues haven't created any major long-term problems, as the interest rate environment has remained benign. If rates start to rise in the near future, though, downward pressure on Treasury prices could lead to less orderly behavior in the bond market. If that occurs and structural bond market problems still exist, then volatility in this market could spook confidence in the entire financial system.

At this point, market participants have an opportunity to take action to make the bond market more secure before a crisis hits. If they wait too long, though, the market itself might make the decision for them.

The article Stocks Aren't the Scariest Financial Market Right Now originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.