At the Financial Times, Amin Rajan explains that a lack of liquidity, which was strangled by post-2008 Financial Crisis regulation, could deepen any future financial crisis.
Put simply, traditional market makers for fixed-income products cannot now warehouse risk because of the effect of the regulation to enhance global financial resilience introduced after the 2008 crisis.
This is best shown by US investment grade credit. It grew by 43 per cent between 2007 and 2018, while dealer inventories were just 6 per cent of what they were in 2007, according to JPMorgan Asset Management. The new generation of intermediaries connects buyers and sellers only when two-way interest exists, and this can be sporadic.
At the same time, the quality of protection built into the riskier corner of the credit market has been falling, according to Moody’s Loan Covenant Quality Index. In this prolonged era of low rates, quantitative easing by the central banks has led investors to climb higher up the risk curve in search of yield. Today, it is hard to get returns in excess of 5 per cent without leverage or aggressive risk-taking across most asset classes.
Worse still, central banks’ quantitative easing has fostered the illusion that pump priming will guarantee liquidity by suppressing normal supply and demand. Convictionless trades now abound, as markets are moved by random psychological forces far removed from the fundamentals. For example, in 2017, 85 per cent of Italian high-yield bonds traded below the yield of the US treasuries.
In fixed income, market liquidity has diminished, as shown by average trade size and price impact. Of course, regulators can insist on stronger safety buffers but this will dilute returns by forcing funds to hold bigger cash reserves.
In the meantime, sudden outsized price moves have been evident in a range of asset classes, yet the bulls keep running and liquidity rears its head only sporadically.
Read more here.
Jeremy Jones, CFA
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