Monday, October 26, 2015

26/10/15: About that Repaired Liquidity


Over recent months, I warned about the weakening liquidity in the global markets in my column for the Village Magazine, for the Manning Financial newsletter. And I covered the topic in my analysis of both the IMF WEO/FSR updates for October.

The problem continues to persist despite monetary policy remaining accommodative.

Per Credit Suisse report (emphasis is mine): “While bid-ask spreads for sovereign and corporate bonds in the U.S. and Europe have narrowed significantly from the wide gulfs of 2008, they are still well above their pre-crisis lows. Sovereign bond markets have also become shallower since the U.S. Federal Reserve began tapering its asset purchases in 2014 – and even markets that look deep based on trading volume can bottom out fast during bouts of volatility."

Credit Suisse points to October 15, 2014, when "U.S. 10-year Treasury bond yields fell 16 basis points and then recovered within 12 minutes, fluctuating 37 basis points over the course of a single trading day" - a rare event that happened only three times since 1998.  "Even for U.S. large-cap stocks, where bid-ask spreads are at their lowest levels since 2007, trades are increasingly clustered in the most liquid hours of the day. One in six S&P 500 stock transactions occurred in the last hour of trading in 2014, compared to one in 10 in 2007." In other words, world's most liquid market is now experiencing trades clustering seemingly linked to liquidity timing. "It also seems to be getting more difficult – and costly – to execute large equity orders. Block trades of more than 1,000 shares comprise just 10 percent of all transactions compared to one-third a decade ago. Bid-ask spreads for U.S. small-cap stocks have also widened relative to large caps.”

In simple terms, all of this indicates that the old regime of ever-expanding liquidity conditions in the markets that prevailed over two decades preceding the Global Financial Crisis are no longer with us.

Credit Suisse attributes pre-crisis markets deepening to three factors:

  1. financial sector deregulation;
  2. technological advances in trading; and
  3. highly expansionary monetary policies


Per Credit Suisse: “…all three trends are reversing course. Dealer inventories fell dramatically after regulators raised banks’ capital reserve requirements and banned proprietary trading in the wake of the crisis. Total trading assets at the top 10 U.S. and European banks have fallen 17 percent since their 2010 peak. On the technology front, Credit Suisse says that “the marginal benefits of innovation in trading are receding” as high-frequency trading speeds push the boundaries of physics. And while zero interest rate policies in the developed world have supported risky assets since 2008, Credit Suisse believes rate hikes from the Federal Reserve and Bank of England could cause liquidity to evaporate from bond markets.”

Which is the same as saying that one a drug addiction kicks in, the highs of each subsequent hit tend to become replaced by the lows of each crash.

And which brings us to the point of concern forward:

  • emerging regulatory environments (separation of banking activities across trading vs retail lines - covered by the EBU reforms and discussed in depth here, introduction of financial transactions taxes - covered here, increased costs of capital buffers - covered in the EBU reforms link above), as well as 
  • changing market structures (rates 'normalisation' and dissipating power of global SWFs - written about here and briefly discussed in the context of early warnings here
all signal more instability linked to liquidity pressures in the markets in the future. Not less. Which is all fine and dandy, except the entire promise of the global financial reforms post Global Financial Crisis has been to lower that said structural instability.

Which is to remind us all that the road to hell is so often paved with good intentions.

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