Could A 2016 Liquidity Crisis Lead To More Market Turmoil?

There has been a lot of talk over the past months of another major turmoil hitting the markets and causing a large correction in stock prices. The view is that this will be caused by a liquidity crisis in the bond markets. A lack of liquidity will mean the market will not to be able to manage with a headline shock or simply a run on an asset class

Why Does Liquidity Matter?

Liquidity is created by market dealers or market makers that offer prices on both sides. That is they show the market a bid price and an offer price. But that is only part of the story, in the past Dealers could keep the positions they took for their clients open. New legislation has meant that banks have to trade all clients’ positions on a like for like basis. They cannot buy a bond from a client for example and keep it on their books in the hope its price will go up. It has to be sold back into the market.

The fact that many Dealers lack the capability to keep positions open means that ultimately, the market will be less able to absorb sharp price shocks. Banks have by far been the largest institutional category to offer market liquidity. In this case we are talking about bonds but it also extends to other assets classes. Liquidity then is necessary to be able to achieve the smallest possible impact in the market when investors try to sell or buy large amounts of a security.

The Possible Cause

New rules and regulations, which have now made it much harder for banks to hold proprietary positions, means there will be fewer prices when an institutional investor needs to exit an investment in bonds. What has been happening lately is that a position of $50 million corporate bonds now takes a lot longer to exit or put on, than it used to. An investor needs to be willing to go through the process of various deals of $2 or $3 million each. That’s ok when the market is stable, but when the markets are moving quickly it may mean you are losing huge amounts of money trying to get out of a particular bond or portfolio of bonds. 

The Fed has just started the transition to a higher interest rate regime. A ¼% rise isn’t much and comments by Fed Chair Yellen seemed dovish on how fast they will proceed. However quickly they decide to raise interest rates, there is no doubt we will most likely be seeing much higher rates by the end of 2016. Inflation has been relatively low over the past year averaging at 0.2% so far, last data showed an increase to 0.5% for the latest month. If inflation continues to rise then the Fed would have even more reason to raise rates at a faster pace.

There hasn’t been a run on bonds for now, but at some point if the market perceives much more hawkish action by the Fed that might change. As interest rates rise current bonds with fixed coupons will be less attractive. If the perception is that rates will start heading higher faster than thought, we could see a much stronger sell off in bonds.

As these securities loose value certain institutions will be forced to sell even more of them, further escalating the downward spiral in price. The lack of liquidity could mean sharp and sever losses in a single day. A scenario of this kind also changes the evaluation of risk and the overall evaluation of risk for the whole portfolio. Now funds with strict mandates will see a large increase in the total risk of the portfolio and be obligated to make sales in their holdings of Stocks and other risky assets.

This would be very similar to what happened in 2008, overall risk increased, institutions with strict limits had to reduce the total risk of their portfolios. Risky assets held by these institutions are typically Stocks and Hedge Funds. Hedge Funds in turn to be able to satisfy redemption calls will also need to sell stocks and bonds, putting further downward pressure on price. Commodities which have fallen out of favor recently may show some attributes of refuge. Gold in this kind of picture may look more attractive, especially if inflation sets in.

Warning Signs?

There are two factors that can give away the onset of a severe lack of liquidity; although it may be temporary like they often are on the back of economic data releases. In times of market stress the temporality disappears as the general crisis sets in, further exacerbating the turmoil. A lack of liquidity can be observed by sharp moves in price with low amounts of securities exchanged. There will also be an increase in the difference between the bid price and offer price.

The chart above shows the difference, also known as spread, between bid and offer price for High Grade American bonds. We can see that this spread is on the rise again since it bottomed out in August 2014 at below 6 basis points. The BASI index is currently just above 9 basis points, which is a long way from the level of spreads seen during the last crisis. Data from MarketAxess goes back to November 2009, the spread at the time was 41 basis points. However this sustained increase is indicative of what the market perceives in terms of risk.

Ultimately we will only see as we move forward the consequences of rising interest rates on the Bond and Stock markets. There is no doubt that the new regulations designed to protect banks from collapse in times of markets stress have hindered the capability of the market place to deal with price shocks. The IMF issued a report about all this last September, their findings although not alarming I’m sure are rising many red flags.