US treasury bond yields caught out many investors in the first quarter, tightening sharply below 4% in February and once more wrong-footing many who had been expecting that they would widen.
Financial institutions have benefited so far. The four US investment banks that announced first-quarter earnings last month had bumper trading quarters, whether from proprietary or customer trading. All easily beat equity analysts' consensus earnings per share numbers as a result, Goldman Sachs managed to do so by 50%.
As for commercial banks the Federal Reserve's weekly h-8 report shows that unrealized securities gains at the "large domestically chartered banks" spiked from $5 billion at the end of January to $12.9 billion in mid-March.
Their holdings of mortgage-backed securities also increased, rising 27%, or $81.8 billion, in one week in mid-February to $379.3 billion, having increased little since the summer crisis.
Bank of America accounts for perhaps half the jump, as it settled billions of forward purchase contracts of both MBS and mortgage whole loans in February. The rest of the $81 billion is probably just betting on the yield curve.
If feels like last summer again, with bond yields at or near multi-decade lows. But a comparison with 1998 might be more to the point? Many in the market might argue that it's not. But a phrase often being uttered is excess liquidity: too much cash is chasing too few opportunities.
It's got more pronounced as yields on safer securities tighten to the level of last summer's. Investors in emerging markets are buying smaller and less liquid paper to get their yields. Try to find a high-yield bond fund without a distressed debt business now; and then try to find enough distressed debt securities to keep them happy, a difficult task since the high demand has bid up many such assets to the point where they are no longer distressed.
Add to that leverage. A report last month by independent research firm CreditSights laid out some anecdotal evidence that leverage might be as high as in 1998, or even higher. According to feedback CreditSights got, investors believe leverage stands at two-thirds to three-quarters of 1998's levels.
But there are factors that might not figure in those assessments, such as hedge fund growth. Last year, according to Tass Research, hedge fund assets grew more than 10% to $750 billion, as opposed to $300 billion in 1998.
Hedge funds' desire to play in the credit markets has increased, reckons CreditSights, using the US Treasury's data on net foreign purchase of US credit assets. Purchases from the Cayman Islands, where many hedge funds are registered, have increased markedly.
Another factor is the increase in the use by banks, traditional asset managers or hedge funds, of credit derivatives, making leverage harder to assess.
Then add on concentration risk: according to the latest survey by the Office of the Comptroller of the Currency, seven commercial banks account for 96% of the total notional amount of derivatives in the commercial banking system.
None of this means that there will be a crisis, or that if there is one it will be on the scale of 1998. Last summer's mini-crash caused a fair number of players some pain but there were no disasters.
Some are taking precautions, though: there's anecdotal evidence that banks are concerned at the amount in long positions they have been holding, and at their value-at-risk limits being almost or totally full. Some are setting up excess liquidity of their own in the form of increased funds they can draw on should market liquidity suddenly dry up. Goldman Sachs, for example, revealed in its 10-K that it has to hand cash and highly liquid securities of $38 billion, with a total backstop of liquidity of $60 billion.
That big correction might not be just around the corner, but there's nothing wrong with preparing for it.