FED HIKE COULD SPARK A BOND MELTDOWN

A new report from Citigroup warns that no matter how the U.S. Federal Reserve raises interest rates this year, it will result in bond market panic.

Bond yields always tend to rise in response to rate hikes by central banks, but the bond market today is much different than during past rate hikes, Citi said. In particular, liquidity has slumped to worrying levels. Some market watchers, such as private-equity titan Stephen Schwarzman, have warned that this could be the trigger for the next financial crisis.

Citigroup isn’t being nearly as dramatic. But it is worried about whether there will be enough bond buyers when interest rates go higher and investors look to shuffle their portfolios.

“Market makers have become less able and willing to supply the needed liquidity and/or effect the required size transactions on demand,” Citi said in a report.

There have been many explanations for the lack of liquidity. The main one focuses on the declining role of banks as deal makers, given a slew of new regulations implemented that have sought to limit the role of investment banks in the market

“Such reduced market-making capacity at a time when everlarger asset gatherers have increased immediate liquidity demands makes the upcoming interest-rate normalization period even more prone to bond market overreaction,” Citi said.

A bond market meltdown in response to a rate hike could also derail plans by the Fed to normalize its monetary policy. Fed chairwoman Janet Yellen has not committed to a timeline on raising rates, but most economists expect the first hike in September.