The trouble with today’s liquidity environment, which must be contributing to the lack of understanding around these events, is that it is very difficult to gauge exactly how much liquidity has fallen. Brainard, in his address to the Salzburg Global Forum on Finance in a Changing World, pointed out: “Although anecdotes of diminished liquidity abound, statistical evidence is harder to come by.”
The extraordinary policy measures taken by central banks globally have served to hide the true extent of the decline. According to Tapan Datta, head of asset allocation at Aon Hewitt: “The paradox of central bank action is that it hides underlying liquidity problems.”
What is clear and certain, however, is that when it is most needed, liquidity will be even harder to find.
As Janus’ head of global rates, Chris Diaz says: “Liquidity is there when you don’t need it and not when you do.”
After all, as the BIS points out, it would not be reasonable to expect broker-dealers to ‘catch a falling knife’ by deliberately exposing themselves to losses when market valuations change. It follows then that marketmakers’ willingness to provide liquidity will disappear when markets are stressed, further cutting their inventories, and are therefore not likely to absorb broad changes in market sentiment even if they are willing to do so when markets are ‘normal’.
CENTRAL BANKS
The central scenario of a smooth path to normalisation is reliant to a large degree on central banks’ ability to manage volatility by altering their QE programmes.
Lyxor’s Barjou believes: “The central scenario should be manageable. Central banks are already starting to think about liquidity and thinking about how to exit QE. They are conscious of the systemic risks and are ready to jump in. We expect they will adapt QE to the fact that liquidity is thinner in order to manage the increase in volatility.” However, the reliance on central banks may be somewhat misplaced.
Aon Hewitt’s Datta argues: “Central banks are learning by doing and are feeling their way very nervously. There is far too much confidence placed on their ability to manage [the normalisation process] well. They have done so far, but their role has become elevated beyond what is reasonable.”
Central banks’ biggest failure over the last 20 years, he continues, has been managing financial stability and preventing bubbles. “It is not clear they have learned the lessons of the past and the tools of the trade they employ are insufficient,” Datta says. Central banks have already made some painful mistakes, not least when the Fed sparked the Taper Tanrum in 2013. Earlier this year the Swiss National Bank also shocked markets when it dropped its europeg, causing severe disruption in the FX markets.
“A lot of people were assuming the SNB would continue to hold back,” says Peter Plester, head of FX prime brokerage at Saxo Bank. “A few days prior, it had said the euro- peg was the cornerstone of its policy. When it moved, a lot of people had been building in stops so the market moved down quickly as those stop-loss triggers were hit, which created a vacuum in pricing. There was a big dislocation in liquidity that wasn’t pretty.”
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