Quote of the Day:
The market can remain irrational longer than you can remain liquid.
John Maynard Keynes
Everyone in the market loves that quote. It’s one of my favourites too. But these days the cautionary quote sends a little more chill down the spine; there is a menacing precariousness to the state of liquidity in the market place – and you don’t have to be a one-armed blackberry-picker in Somerset to know this.
Roubini’s article, The Liquidity Time Bomb, draws reference to the fact that we are in, what he calls a “Liquidity Paradox”. The paradox being thus: for all the liquidity being pumped into the global economic system, the net effect of policy meddling is that there is less, not more, liquidity in the financial markets. Roubini harks to a, frankly, awesome macro research piece by Citi’s Matt King. The piece is also highlighted in a ZeroHedge article, Nor Any Drop to Drink, which expounds the liquidity paradox with, of course, the satirical cynicism for which their blog is renown. The blogosphere is twittering and well-known market participants and commentators are regularly referring to it. This summer an FT article referencing the Citi research team’s liquidity paradox opened with the simple sentence: welcome to the desert. I really recommend opening this FT article, if only to look at the pictures – there are some fairly remarkable charts on trading volumes and market turnover.
Why should we care? Well, the argument is that this lack of liquidity leaves us open to what Matt King and ZeroHedge call “air pockets” – asset price shocks and volatility spikes. He points to some interesting trends which illustrate just how our liquidity has deteriorated – some of which I have attached below.
But why are we worried about liquidity today? One could argue there has never been more liquidity in the World. Every single central bank in the world appears, not just to be easing, but hell-bent on unconventionally aggressive money-printing measures such as ZIRP (Zero Interest Rate Policy), outlandish dovish official guidance, Quantitative Easing and Asset Repurchases and, in China’s case, outright stock manipulation and political coercion (intimidation?) with a simple objective: to increase the supply and velocity of currency in the economic system. That is; central banks and the economic authorities seek to drown us in the most liquid asset of all: cash. I could tell you why they are doing this… but that is another story… and should be told another time… (I say that quite a lot, apologies in advance)
As usual, in the beginning, the rationale is righteous; by reducing interest rates one encourages businesses to borrow and finance capex and investment, feeding positive energy back into the economy a process which self-sustains in a phenomenon Keynesian economists often refer to as The Multiplier Effect. That’s the theory, at least. Practically, however, as the real “good inflation” (wage inflation invoked by increased economic activity) fails to take hold, in true Richard Koo-Style Balance Sheet Recession, the effects of exploding the Monetary Base mutate into a new, more sinister beast. From businesses being gently enticed into investment, we find consumers (that’s us) being pressured out of the drought-lands of conventional savings, by the pain of negative interest rates* and into either fruitless consumption or prevailing asset bubbles in property or stocks – the very assets prone to over-crowding, air-pockets and price-shocks.
The comfort of liquidity is a mirage, to use my blackberry-picking paradox: blackberries, blackberries everywhere nor any fruit to pick. Despite massive amounts of liquidity in our economic system, the ripened fruit of market liquidity is superficial, illusionary in some areas and outright delusionary in others. Where it does exist, we must often overstretch to reach it. The money-printing, liquidity-flooding philosophy of our monetary authorities even spills into the geo-political arena with new saber-rattling over currency wars – a topic which have touched on many times. But that is another story… and should be told another time…
It’s hard to overlook the irony isn’t it? In a world awash with liquidity, we are fretting about illiquidity in financial markets. So what is causing this lack of liquidity? Matt King of Citi and Nouriel Roubini argue that there are three main causes:
- High Frequency Trading: produces unnatural surges in liquidity at certain times in the day but leaves vacuums at other times of the day, distorting volume distribution. The individual computer algorithms trading securities are, of course, highly sophisticated, but the net effect is that they exacerbate “herding mentality” of the markets – this is a characteristic the markets do not need help amplifying! There is also another aspect of herding which is interesting. During herd-like behaviour, it is as though individuals (investors) lose perspective of the world outside the herd. Perhaps it is the animal herding instinct of the “safety in numbers” at play. But, consequently, we find that prices are prone to deviate from the fundamentals of “fair valuation”. The markets are prone to trade rich and, because there is less attentiveness to absolute valuation, dealers and investors alike are more likely to be on the same side of the trade (long) for longer periods of time, offering little resistance as valuations move yet higher. Greg McKenna of Business Insider, quoting Matt King, puts this more succinctly than I can in his short piece on the topic:
The problem at the moment is that, as King says, ‘Markets are liquid when they work both ways.’
But markets are all heading in the one direction because central banks are creating artificial liquidity on the way into these globally uni-directional trades where ‘market participants… find themselves increasingly needing to move the same way.’
[Source: Citi Research]
- Prolonged extreme (accommodative) monetary policy is repressing investors out of safety. Many of the securities traded these days, like government bonds and corporate bonds (e.g. investment grade and high yield straight bonds and convertible bonds) are traded OTC. Firstly, these are inherently less liquid. This is not much of a problem, normally speaking, but the herds of investors are migrating into these OTC bond markets motivated, not by the pull-effect of tantalizing fresh pastures but, rather, the push-effect of a barren liquidity/return on “cash equivalents”. Just like I, the consumer, under the gloom of negative real interest rates, is being coerced out of keeping my money in the bank account and into precarious asset bubbles, investors used to transacting in the low volatility, very liquid, very short-term investments – such as Commercial Paper, Repos and short-term govvies – are now being coerced into using the longer, riskier OTC bond markets as their “pseudo-cash equivalents”. Note: if we’re using the word “pseudo” and “equivalent” in the same sentence we’re already a long way from sensibl
To make matters worse, there is mismatch in the investment horizon building across the OTC bond markets, generally. Previously, long term investors, such as Pension Funds and Insurance Companies used to own large segments of the OTC bond markets. These days, though, their dominance is being dwarfed by a massive growth in mutual funds. Again, this is in part due to us, the retail investor, being forced out of an easy-access savings account and into what your bank manager may call “a managed fund”. Either way, because these funds are open-ended – I, the retail customer, can withdraw my funds at any time. The long term investment market of OTC bonds is being dominated by funds with short term money flows. That’s a recipe for disaster, indeed, ZeroHedge say mutual funds “may be setting the stage for a veritable maturity mismatch massacre”. [Source: Citi Research]
- Volcker Rule is taking the liquidity-providers out of the game. In the old days, banks, with their beefy facilitation books and prop books, which could use balance sheet and were not subject to fickle investor-flows, would add a level of objectivity to market in-flows (selling into a rising market) and a degree of cushion on an air-pocket-induced falls and outflows (buying on the dips). The Volcker Rule means this mechanism has all but vanished. The financial markets are effectively speeding down the freeway without a liquidity seat-belt.
Roubini calls it a “Time Bomb”, ZeroHedge use the phrase “powder keg” whereas commentators like El Erian have the slightly less alarmist tone pointing to a “Quiet Financial Revolution”. But what is becoming clear, is that there are asset bubbles within the financial markets which have been fueled by central planners and policy-makers (primarily our central banks) in a reaction to a financial crisis caused, in the first place, by the collapse of an asset bubble (Sub-Prime Asset-Backed Securities). A bubble which, in turn, was caused primarily by excessively accommodative stance by central planners – see a trend here? Welcome to Hair of the Dog Monetary Policy. We are suffering from the ingestion of a poison and the only cure we can think of is to drink yet more of the very same poison. The irony of the liquidity debate is not lost either – in the honorable desire to increase liquidity, we are also destroying it and creating a complex web of market distortions which is herding investors further and further from rationality.
Don’t get me wrong, investing in financial assets has yielded amazing results over the last 5 or 6 years while the cost of holding cash has been high. I have no idea how much longer this can go on for, but it can’t go on forever. The question is; how rational do you think you are? Are you tempted to jump on the next asset price gravy train? John Maynard Keynes was correct, but the real question may not be whether the market can remain irrational longer than you can remain liquid, but, rather, whether the market can remain illiquid longer than you can remain rational.
*I don’t know about you, but my bank effectively gives me negative nominal interest rates when one accounts for fees, penalties, cost, taxation and commissions. When one accounts for inflation then the “real interest rate” is harshly punitive (negative). It actually costs me to hold my money at the bank, which almost compels me to take my money out of the safety of my account and into the welcoming arms of the next potentially calamitous asset bubble. Our savings are continuously in danger of becoming what Mauldin refers frequently to as a “bug in search of a windshield”. And remember, many people think they put their money in the bank for safe-keeping, that’s what central planners would like you to believe, but try telling that to the owners of Northern Rock accounts. Upon inspection what we are actually doing is more accurately described as lending money to a bank – which then goes and churns it into a leveraged banking system via a process known as fractional reserve banking. Why did Bank of England Governor, Mervin King, hesitate before bailing out Northern Rock? What was all that hot air about “Moral Hazard”? The reality is Mervin King did not bail out Northern Rock because he wanted to help all those little old ladies who had their life-savings deposited there. Merv “the Swerv” King bailed the bank out because he had no choice – had he not done so he would not have had a banking system left to preside over…but, of course, that is another story… and should be told another time…