Remembrance of Things Past – Liquidity, Stability, and Predictability

Financial markets are imbalanced and lack liquidity in crucial sectors, even historically stable and predictable markets such as the global bond and currency markets. Investments are slanted in one direction more frequently and the markets are vulnerable to big price swings as a result. These large global markets are not immune to ever more lopsided trades creating extreme volatility. This occurs even when a small change occurs in positions, sentiment, or news.

Even the world’s most liquid markets, US dollar currency trades and US Treasuries, are seeing skewed positioning resulting in surprisingly large shifts in prices and Treasury bond yields.

What’s Happening?

Using the most liquid trades available from the currency markets, we can see how a market that trades $5 trillion worth of currency daily can become suddenly illiquid, dramatically impacting prices and making any long-term prediction challenging.

These large markets hide a fundamental shift toward illiquidity. Using the most popular currency trade illustrates the role liquidity plays in price volatility and sudden market swings.

If We All Run for the Door at Once

Suppose you want to position a trade based on recent news where you conclude that the US economy will grow faster than the European economy. Therefore, you conclude that interest rates will rise in the US relative to Europe. If that’s the case, the US dollar will rise relative to the euro. This prediction is based on news regarding a new outbreak in Covid infections. Additionally, you predict increasing partial lockdowns in Europe are likely, and the Euro-wide economy will be impacted negatively. In the meantime, America seems to be faring better. Its economy is picking up, inflation seems less transitory, and lockdowns are off the table (for now). Therefore, a reasonable trade would be to bet on the Federal Reserve raising interest rates and the European Central Bank keeping rates the same (or even lowering). One way to profit from this prediction is to short the euro against the dollar.

But, wait a minute. The Commodity Futures Trading Commission publishes positions of traders in currency futures and options. Upon checking the CFTC data, this position is already crowded. Therefore, there are fewer potential sellers to drive down the value of the euro against the dollar, and this lack of balance in the trade – illiquidity – poses several significant risks. One, if sentiment improves for the euro, there will likely be a short squeeze, driving losses as traders buy euros to cover their short positions.

Another, if sentiment changes in general, even without a short squeeze, as news continues to be uncertain and speculative, prices will move dramatically and erratically because the market now has an imbalance of sellers and buyers. Prices are a function of supply and demand, and if supply is increasing dramatically while demand

remains low, price shifts are magnified. This news creates a vicious cycle where those magnified price movements trigger additional supply and demand driving even greater price movements. It is now a global phenomenon for all securities.

Immune No Longer

While this example shows the impact of a currency trade, we are seeing the same impact from illiquidity in Treasuries – another supposedly large, liquid, and global market allegedly immune from illiquidity. But it is not. A smooth liquid bond market has become unpredictable, volatile, and less liquid. Essentially, the hidden driver to this volatility is also illiquidity. As surprising as it now seems, it is increasingly challenging to move in and out of bond positions quickly, and prices become more extreme.

When the Fed is Gone

Excessive liquidity created the opposite effect in March 2020 and February 2021, according to a report from the Treasury Department and Federal Reserve. It showed that the Fed providing excessive liquidity enabled bond prices to stabilize after dramatic jumps in bond yields resulting from extreme negative news regarding the pandemic. Now that liquidity from the Fed is being withdrawn as it tapers its bond buying despite increasingly bad news and quick-changing investor sentiment.

The market is experiencing more frequent and extreme price movements and it does not look like the Fed is coming to the rescue anytime soon. Uncertainty and less liquidity are increasingly extreme in what would otherwise be considered a liquid and more stable market with transparent price discovery.

I’m the Government and I’m Here to Help

Today’s circumstances can be connected back to regulations enacted after the global financial crisis of 2008. These made it much more expensive for banks to hold large inventories of bonds to facilitate trading. This lack of inventory available to supplement proprietary and client trades has greatly reduced market liquidity, especially in treasury bonds. Now, a small group of electronic high-frequency traders has filled the void created by these new regulations.

The high-frequency traders keep the market liquid most of the time – except when it matters most. They are thinly capitalized and therefore cannot hold bonds in inventory. In volatile markets, these firms are forced to take less risk because of their thin capitalization. The bulwark against short-term illiquidity and volatility is gone.

Stability and Predictability?

So, when liquidity is most needed in the bond market, it vanishes. This is not a good formula for stability, long-term predictability, and price discovery, and is driving even more extreme volatility because there is no prospect of additional liquidity being provided to the market anytime soon.

These changes in market structure make positions more extreme. In addition, bond buyers are a relatively homogeneous group. Funds are bigger. Information flows quickly and is available to all. Momentum trading is far more prevalent in bond markets and algorithmic trading magnifies the imbalance, buying recent winners and selling recent losers, driving these price differences further.

The Madness of Crowds

Before the financial crisis of 2008, market-makers were willing and able to defend against momentum and take a long-term view based more on fundamentals than immediate market sentiment. Large banks could hold inventories of bonds and be patient as volatile forces pressured the market, acting as an effective counterbalance.

Not anymore. Positions are crowded, and when sentiment goes against a popular trade, price movements are sudden and dramatic. Any semblance of rationality to the market is an increasingly distant memory.

The market now leans too far one way or the other, and that imbalance will be forced to reverse more powerfully and unpredictably.

The Road Ahead

Even in the world’s most liquid market, trades are increasingly imbalanced, and liquidity is drying up. Large positions that cannot be held for days (or even seconds) combined with illiquidity will cause more extreme and frequent volatility in the global bond market, and that will impact all other markets, from currencies to equities more dramatically.

Don’t expect stable or smooth markets anytime soon.