Illiquidity is a very real risk that is yet to be truly tested. As long as central banks continue to pump liquidity into the system, the full effects of regulatory changes on banks’ willingness to hold inventories or make markets in securities cannot be fully understood.
The IMF’s April Financial Stability Report points out that markets could be more susceptible to periods when liquidity vanishes and volatility suddenly spikes. The report points to the October 2014 volatility in US Treasuries and the January 2015 surge in the Swiss franc as recent examples of how an initial shock was amplified by market makers’ withdrawal of liquidity support.
The report states: “Many of the factors responsible for lower market liquidity also appear to be exacerbating risk-on/risk-off market dynamics and increasing cross-asset correlations during times of market stress. These phenomena suggest that low market liquidity may act as a powerful amplifier of financial stability risks.”
The result of all this is a world that is increasingly sensitive not just to interest rate risk, but to volatility risk.
Shocks can take many forms from a bond guru referring to the bund as “the short of a lifetime” to the on-going eurozone crisis, which could still result in a Grexit, or from the dangers of a rapidly remilitarising Russia trying to destabilise another of its neighbours, to name but a few.
Even on the economic front, the chances of a shock are present and real. Henderson’s O’Connor warns of the risks investors face as their search for yield has increased their vulnerability to tail risks. He talks of the possibility of a “positive growth shock where, for example, we might be looking at three Fed rate hikes that leads to a largescale Taper Tantrum; or a negative growth shock where it is clear central bank policy is not working”.
“Risk assets have been hurt by that in the past,” he adds. “For investors holding less government and more corporate debt and/ or infrastructure, for example, their portfolios won’t do well at all in that environment. The risk is amplified given the fact we don’t really know the liquidity of these areas that have grown very quickly as it has not been tested.”
THE BIG QUESTION
The big question for investors is whether their risk models are built for this strange new world. Risk models and technology have moved on considerably from where they were in 2007/8 with scenario testing taking centre stage and a greater focus on liquidity, but has investor behaviour followed the same path? Have the lessons really been learned?
Axa’s Lustig believes there is still a basic problem with risk models in that they combine measurement – quantitative tools to measure exposures – with management, which involves judgemental decision making to mitigate risk.
“How do you give probabilities to risks when everything is distorted?,” he asks. “Pricing models of swaptions, for example, cannot deal with negative interest rates. Some risk models just can’t cope with today’s environment.”
UBS’s McCallum argues: “It is important to carry out scenario tests rather than focussing just on recent history. Risk is uncertainty so by definition it is a probability distribution. As soon as that is summarised into a single number, a lot of information gets lost. Even if all the risk models have been updated on the buyside, it is still a question of how investors behave. Can they hold their nerve and distinguish between an event that is causing volatility and one that changes the outlook for the future. They look the same at the outset.”
McCallum also points to the common human failing of everyone believing they “can get out of a trade before everyone else”. Yet, in truth, experience teaches us time and again how hard it is to time the markets.
In a world where investors take ever-greater risks and perhaps underestimate the extent to which they are doing so, those risks are rapidly building and have yet to be truly tested. While risk models have moved on, managing risk is still heavily reliant on human judgement and the ability of an investor to make accurate predictions about the probability of market outcomes. And some shocks simply cannot be predicted, which will hurt investors who are increasingly sensitive to interest rate, currency and volatility shocks as the fate of their assets are more closely bound together. The outlook appears increasingly fragile.
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