Central banks appear to have everything under control, but recent volatility spikes raise serious concerns about market participants’ understanding of liquidity. Emma Cusworth questions their sanity.
“People are quite blase today. They are always prone to optimism until something smashes them in the face.”
Mark Pumfrey
According to the Urban Dictionary, when something is ‘off its rocker’ it is out of control or no longer works correctly. It’s very possible this is exactly the situation that financial markets find themselves in today. Recent times have seen severe and inexplicable volatility spikes in certain markets, notably fixed income and FX, which raise serious concerns about whether or not market participants really understand the liquidity environment we find ourselves in today. And if there is a deficit of understanding, how can the associated risks possibly be priced in to markets?
Yet, despite this, conversations with a large number of those market participants seem to suggest a widespread belief that the central scenario for the coming years is a smooth yield normalisation process, with central banks proving themselves capable of carefully guiding markets through any potentially rough patches. These two factors don’t appear well-matched.
THE DEATH OF LIQUIDITY
As Peter Martin, head of manager research at consulting firm JLT Employee Benefits says: “There is some consensus things will sort themselves out over time, but in my experience, that is the time to start worrying. There is a lot of stuff that could go wrong – a hard landing in China, or a slowdown in the US, for example, would have a big impact. Markets usually cope well with a single event, but it gets interesting when there are a series of events.”
It also looks interesting in the context of a dramatically different liquidity environment since the financial crisis, which is proving to be a source of concern for many in the investment industry.
According to Mark Pumfrey, head of EMEA at Liquidnet: “An unintended consequence of regulation has been to tighten liquidity. No one really knows how that will play out, but it will create more volatility than in the past. Institutions desperate to find yield have loaded up their portfolios with trades they will have to find the other side of. There will definitely be a crush.”
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