| Welcome to the Weekly Fix, the newsletter that's getting a bit big for its britches and may need permanent central bank support. I'm cross-asset reporter Katherine Greifeld, filling in for Emily Barrett. Too Big to FailFed Vice Chair for Supervision Randal Quarles turned heads this week. His comments got people thinking about whether the U.S. debt market is now so big that it may need permanent central bank involvement. While discussing the outlook for the Fed's bond-buying program, Quarles said it's an " open question" as to whether there will be an indefinite need for the Fed to keep buying U.S. bonds to support market function: "It may be that there is a simple macro fact that the Treasury market being so much larger than it was even a few years ago, much larger than it was a decade ago and now really much larger than it was even a few years ago, that the sheer volume there may have outpaced the ability of the private market infrastructure to support stress of any sort there," Quarles said during a virtual panel conversation on the future of central banking hosted by the Hoover Institute on Wednesday.  Quarles was quick to clarify his comments the next day, this time after a speech to the Institute of International Finance: "I wouldn't want the comments that I made today about thinking about Treasury market structure to suggest that I think that there's some need for some permanent backstop of the Treasury market in normal times," Quarles said in response to a question. Regardless, the episode was a reminder of just how large the Fed's footprint in the Treasury market has grown since March. After bond market liquidity deteriorated in March's coronavirus turmoil, the central bank ramped up purchases in an effort to restore functioning. Now, even with markets seemingly back to normal, the Fed is still buying about $80 billion of Treasuries a month. The market for Treasury securities has ballooned to more than $23 trillion, from roughly $15 trillion five years ago. And while Quarles doesn't see the need for the Fed to become a perpetual presence in "normal" times, make no mistake -- central bankers have previously signaled the Fed is ready to dive in even deeper should the economic recovery hit trouble. Volatility MismatchWith the U.S. presidential election coming ever closer, bond and equity traders are seemingly at odds over likely volatility in the aftermath. The Cboe Volatility Index -- the equity market's "fear gauge" -- has been relatively rangebound over the past month. But the ICE BofA MOVE Index -- the bond market's equivalent measure -- shot higher. Credit Suisse Group AG's Mandy Xu says traders are pricing in two sides of the same story. Democratic nominee Joe Biden has handily vaulted ahead of President Donald Trump in the polls, easing fears of a too-close-to-call election. As a result, fears of a contested result are vanishing quickly from the equity market. However, bond traders are bracing after letting implied volatility measures languish near record lows for months. The current calculus in markets is that Democrats would turn on the spigots and unleash another round of stimulus should a so-called Blue Wave materialize -- boosting Treasury yields in the process.  "For the bond market, I would say the biggest risk is a Democratic sweep, in which case you can have a massive deficit-financed stimulus bill that would drive bond yields significantly higher, and that's why you're seeing volatility in the bond market start to pick up," said Xu in a Bloomberg Television interview. "In the equity market, what investors care about is a close or contested election. As the probability of a Democratic sweep goes up, that risk premium has come in." Of course, 2016 dealt traders a harsh lesson in the unpredictability of politics. But for now, it's clear that the consensus is building behind a banner election cycle for the Democratic party. Currently, PredictIt's market for betting on a Democratic sweep shows odds of roughly 57%. Treasury Yields Won't Give Banks a BreakWall Street's biggest banks kicked off third-quarter earnings season in a big way this week, but financial shares overall were limp -- and part of the blame for that lies with the bond market. The earnings reports themselves came with many superlatives: trading revenue jumped more than 20% for a third straight quarter, net income for the five biggest U.S. firms more than tripled that of the second quarter, and loan loss provisions -- the boogeyman from last earnings season -- grew by a scant $172 million for the top five. By most measures, it's fair to say that the big banks passed this round with flying colors. The stock market tells a different story. Financial shares did get a lift on Thursday, but are still down about 1% for the week so far, despite some solid earnings reports. Zooming out, the sector is down nearly 19% year-to-date -- meanwhile, the S&P 500 index is roughly 8% higher in 2020. This chart courtesy of Bloomberg's own Joe Weisenthal helps to explain why investors are still wary overall. It plots the 10-year Treasury yield against the ratio of the Financial Select Sector SPDR exchange-traded fund and the SPDR S&P 500 ETF Trust. The correlation is clear:  A basic tenet of banking's business model is to borrow at short-term rates and lend out at longer rates. That's a tough way to turn a profit when the 2-year to 10-year yield curve can't seem to break above 60 basis points. And with the budding reflation bet in the bond market held hostage by stop-and-start U.S. stimulus talks, it's unclear what will generate the sustained inflation needed for the long-end to sell-off meaningfully. "Whether it's because of growth concerns or the Federal Reserve, bank profitability continues to be very tied to the interest rates and the yield curve," said Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors. The stock market may also be signaling that the pandemic augurs more pain ahead for financials -- in particular, that the $50 billion the banking group earmarked for potential loan defaults likely isn't coming back. And don't forget the U.S. election (how could you?). A Democratic sweep, if it materializes, may increase odds of a fiscal package -- and inflation! -- but worries about increased taxes and regulations could take a toll too. ETF Liquidity MirageETFs are in the hot-seat after some troubling research from the Swiss Finance Institute's Efe Cotelioglu, who found evidence that investment-grade bonds share similar liquidity characteristics when they are heavily owned by ETFs. That's a problem, since it means that in any market shock, investors trying to offload bonds will have a hard time exiting positions across all of them. "Higher ETF ownership of investment-grade corporate bonds can reduce the ability of investors to diversify liquidity risk," Cotelioglu, who is also a PhD candidate at the University of Lugano, wrote in a paper. The findings are fodder for ETF naysayers, who have long argued that the highly-liquid funds could become a destabilizing force for their less liquid underlying securities when markets go haywire. That debate became more urgent in March, when bond markets froze and huge gaps emerged between the prices of ETFs and the bonds they track. Only the Fed's unprecedented intervention restored calm.  Interestingly, so-called "liquidity commonality" wasn't found between high-grade corporate bonds and mutual fund ownership. Cotelioglu chalks this up to some key structural differences: mutual funds have "discretion" in deciding how to meet redemptions, while an ETF can't choose what assets it sells. Additionally, ETFs' intraday trading tends to attract investors with higher liquidity needs versus mutual funds. Still, March's meltdown has done little to slow this year's boom in fixed-income ETFs. Bond ETFs have pulled in about $170 billion in 2020, surpassing equity inflows and already beating last year's record $154 billion haul. Bonus PointsThe New York Fed wants you to prepare for the risks of love and Libor's exit The corporate bond market is seen lacking key data in the electronic era Almost 2,000 Robinhood Markets accounts were compromised in a recent hacking spree The U.S. presidential campaign has already been a roller-coaster ride for global investors, and it promises to get even more intense. Join us virtually on Oct. 21 at 1 p.m. Singapore time (GMT+8) to hear how Kathy Matsui, vice chair Goldman Sachs Japan, and Brian Barish, president and CIO of Cambiar Investors, are preparing their portfolios. Register for free here to be part of the conversation or to access all content on-demand at your convenience. | 
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