Central bank policy and regulations have made the markets illiquid. This combined with herd-mentality trading will have a negative impact on the economy when markets start re-pricing assets based on different valuation scenarios, which can happen unexpectedly and very quickly. Thus, the inevitable asset price correction and adjustment to new levels will be very painful in the near future.

Price instability

The global markets have a liquidity problem. This is evident from the rapid swings in equities, commodities (oil in particular), FX and most notably the bond markets. There have been notable “air pockets” in price, as labeled by traders. These are areas where slippage occurs. Slippage can be defined as the expected price of a trade and the price the trade actually occurs at. It usually happens in highly volatile or illiquid markets.

At a time where global central banks have been easing for years and have pinned interest rates at near zero or even negative as well as engaged in unprecedented Quantitative Easing (QE) programs, this should not be happening.

Chief Executive of the Institute of International Finance (IIF), Tim Adams, recently stated that liquidity has been determined as the top issue in the meetings he’s had with central bankers, CEOs, and financial institutions.

Misconceptions about Liquidity

In a recent memo, famed hedge fund manager Howard Marks of Oaktree Capital succinctly addressed misconceptions about liquidity and what the important definition of liquidity is.

“But the more important definition of liquidity is this one from Investopedia: ‘the degree to which an asset or security can be bought or sold in the market without affecting the asset’s price,’” said Marks. He added:

“Thus the key criterion isn’t ‘can you sell it?’ It’s ‘can you sell it at a price equal or close to the last price?’  […] For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.”

The chart below shows what happens in a market that has high money liquidity propagated by central bank policies accompanied with low trading liquidity. Events of +/- 4 standard deviations at one time were extremely rare, but since the end of the global financial crisis and the beginning of central bank intervention, a different picture has emerged amongst all asset classes.

Reasons for Illiquidity

The main reason cited for the liquidity problem is very harsh regulations that have been imposed, which have made it almost impossible for traditional and investment banking to play its classic market-making role. The market maker’s exact role is to provide liquidity to markets particularly in times when no one else will.

In light of the regulations, those who once filled this role are holding way less inventory than they used to. Chief Economic Advisor, Mohamed El Erian, states:

“Tighter regulations and less patient shareholders have restricted the ability of broker-dealers to deploy their balance sheets counter-cyclically. As such, they have limited appetite when it comes to accumulating inventory in the event that a large chunk of the investor base decides to go the other way. The result has been a series of sudden out-sized price moves in quite a range of markets, from sovereign bonds to foreign exchange, emerging markets, and high-yield corporates. Fortunately, due to the stance of central banks, most of these episodes have proven -- at least so far -- to be short in duration, temporary and reversible.”

Another reason which has particular significance to the bond market is that in the 8 years corporate bond inventories in the US have dropped by 75% and by 50% in Europe. At the same time, due to the regulations which have been passed, banks are required to hold more bonds on their balance sheets.

The QE by central banks has caused these entities to hold bonds of all timeframes. This has taken a tremendous amount of supply out of the market. The result of this is shown in the chart below when the market moves in one direction without liquidity.

This is a massive move in a very short time.  What this shows is a negative feedback loop, meaning that if traders are positioning themselves for a lack of liquidity, this can further reinforce that lack of liquidity as traders and investors shrink their position sizes and become more cautious and unwilling to take on more risk. In fact, they are likely to hold for shorter time periods and have a quick trigger finger to exit positions due to these so-called “air pockets.”

The Liquidity Paradox

Liquidity paradox is a term coined by Citibank analyst Matt King to explain Central Bank policies of QE and extreme easing, which has herded investors into risky assets to get returns at a better rate than near 0%. According to Citi, this has caused “large scale mismatches in the number of buyers and sellers.” This has resulted in this liquidity paradox:

“[…] because the more liquidity central banks add, the higher the risk of a serious liquidity crunch -  started out in corporate bond markets but is now distorting government bond, currency and share markets. It says while the post-financial crisis crackdown on own-account trading by investment houses was partly to blame for a decline in professional market-making, the increased difficulty of finding buyers because everyone is selling at once owes more to central banks' hold on financial markets since the crisis.”

These policies have led to distortions in the capital markets and most people investing in the same way (herd-like investing), which has exacerbated the liquidity problem. Unwinding these trades is going to be problematic due to the massive one-sided trading.

Dornbusch’s Law

"The crisis takes a longer time coming than you think, and then it happens faster than you thought it would."

- Dornbusch’s Law

In other words, Dornbusch’s Law states that financial crises take a lot longer to arrive than one would think and then pass much faster than expected. So you have a chance to be wrong twice.

While everyone thought the collapse of global economies would bring on the next crisis, what if the boom-bust cycle isn't what's going to cause the next crisis, but recognition that 2009 is behind us and zero interest rates awash with money liquidity are distorting asset class prices?

A great re-pricing in interest rates (higher) in an illiquid market could send shockwaves to all asset classes.

If this recovery happens faster and the central banks do what they do best - which is being reactive rather than proactive - interest rates will spike and choke off a nascent recovery roiling the markets because everyone is wrong-footed. Thus, people might actually have to invest again and not wait for “the Fed Minutes.”