10 of a series of Macro & Market themes in which a team of lead economists discuss cyclical and structural dynamics that will drive markets next year
Liquidity only there until Needed
Declines in the volume of trades, market-making and brokering have fostered concern that market liquidity could fall sharply as the Fed raises policy rates, leading to a substantial overshooting of prices on the downside.
In fact, there were two episodes of high market volatility in 2015, with rather different results. The sharp rise in sovereign yields in February, following January’s slide, was comfortably absorbed. There were no serious instances of overshooting of price adjustments. However, the plunge in equity and other risky-asset prices in August did involve a liquidity-driven overshoot, with trading limits triggered on some equity exchanges before order and balance could be restored.
Liquidity and Risk in Conventional Fixed-Income Markets
Over the past two years, there have been episodes of portfolios with short-to-intermediate-term investment horizons reducing their holdings of less liquid assets in fixed-income markets. That shift of liquidity risk into portfolios with longer investment horizons should lessen asset sales as the Fed hikes, reducing the demand for liquidity. Correlations between equity and corporate debt remain high and leverage has been building, so corporate debt is unlikely to be treated as a refuge from volatility, but it may be less vulnerable to shocks than has been feared.
There has been a shortening in the chain of intermediaries in the repo market, which amounts to a reduction in the number of counterparties that can break the chain of asset ownership. The reduction in intermediation has reduced the number of transactions far more than the amount of lending being provided through repo transaction. Repo credit is still vulnerable to sudden reductions in the face of a rise in perceived default risk, but risks to the chain of ownership have been reduced.
Extensive research—by central banks, international financial institutions and banks—has found little evidence of structural faults that would be likely to lead to liquidity problems in conventional fixed-income markets. There has been a big change in the structure of the fixed-income market since the Great Recession, but not to the extent that most of those markets cannot function under stress.
Although Treasury yields will likely stay compressed on average, any change in market views of what the Fed will do henceforth could lead to periods of Treasury price volatility. Such changed perceptions could cause volatility all across the Treasury curve, but the long end is particularly vulnerable to variations in market views of the terminal policy rate.
The progressive decline in dealer inventories of corporate debt in the investment-grade fixed-income market may represent an exception to this. One reason for the decline is the cost under new regulations of holding corporate debt on dealer balance sheets. However, that does not seem a good explanation for an outright short. The dealer short position actually represents a natural bid for corporate debt when prices fall.
Systematic Investing, Exotic Hedging and Internal Market Fragility
There is greater reason for concern in equity and equity derivative markets. The equity market micro-structure has undergone significant changes in recent years, leaving it more fragile and prone to significant volatility beyond levels justified by underlying economic fundamentals.
In effect, an extended period of low rates and central bank asset purchases in an environment of weak and uncertain growth prospects has led many investors to seek income-enhancing strategies. Indeed, extended monetary accommodation and a steep volatility curve, have prompted investors to aggressively short volatility in order to generate income.
Systematic strategies have proliferated in recent years, inspired by poor performance of active investing and advances in financial technology. Commodity trading advisors, for example, have an estimated $300 billion-350 billion in assets under management—a seven-fold increase since 2002. That proliferation has meant that some systematic strategies are widely employed and are an increasing source of market liquidity. A widespread pullout from common trading strategies could lead to a drying up of liquidity in the affected assets.
Finally, high-frequency trading is, in an important sense, computer-based liquidity provision. That source of liquidity has gained share at the expense of liquidity provided by active human managers. When market shocks significantly change the stable correlation structures assumed by the trading algorithms, a common result is heavy selling of assets, and market dislocations. That is particular worrisome when regulatory constraints on balance-sheet risk have reduced the ability of market-makers to step in when markets are disrupted.
The decline in stock prices in August on the back of China’s currency devaluation is a prime example. As we highlighted then, the severe decline in equity prices was largely the result of technical selling from trend-following systematic investors, volatility-targeting strategies and short gamma strategies.
Most of these strategies are convex trades and highly susceptible to volatility-regime shifts and/or trend reversal. As a result, they tend to exacerbate price swings and impair liquidity in highly uncertain times.
However, in this cycle, the reliance on systematic and high-frequency trading will likely keep volatility measures swinging around when growth stalls or geopolitical surprises occur and policy makers are only able to respond in a muddled way to such shocks. For instance, the surge in short-volatility ETN volumes this year, with many retail investors participating, could prove a very disruptive force as such crowded trades can easily reverse.
Given the maturing of the business cycle, the extended “search for yield” driven by low rates and quantitative easing, the reliance on systematic and high-frequency trading for liquidity and the reduced provision of liquidity by traditional market-makers, we expect the uptrend in volatility with temporary sharp sell-offs that we have seen since 2014 to persist.