Liquidity squeeze amplifies market swings

Fixed Income Investment Director Michael Lake believes that the market volatility since the start of the year is largely sentiment driven and has been exacerbated by a lack of liquidity.

11 February 2016

Michael Lake

Michael Lake

Investment Director, Fixed Income

Conflicting signals challenge investors

Since the turn of the year, markets have been driven by sentiment rather than fundamentals.

In this uncertain environment asset prices do not, in our view, reflect the underlying economic data and are driven by powerful emotional responses, not well-reasoned argument.

Reduced liquidity in markets has exacerbated the moves in asset prices as sentiment has shifted, and we believe these market dislocations have created value in assets that are now priced for an economic contraction.

Arguably, markets gave up trading in line with fundamentals well before the start of the year, but a new year has not brought fresh perspective, just aggravated old wounds.

Financial market participants are currently challenged by a range of conflicting signals.

Not only are investors grappling with uncertainty over the nature of the collapse in oil price and its impact on the global economy, but also uncertainty regarding the outlook for China, and regarding the reaction function of central banks amidst tightening financial conditions.

The US Federal Reserve Senior Loan Officer Survey (Figure 1) - a survey of the lending activities of large US domestic and US branches of foreign banks - illustrates that financial conditions tightened for both large and small firms alike during Q4 2015.

In the meantime, investment grade1 credit spreads (Figure 2) and high yield spreads2 have also widened.

This represents an overall contraction in capital available to businesses, as well as a reduction in liquidity in financial markets as banks have less appetite to hold risky assets on their balance sheet.

During recent years, markets have also witnessed a reduction in the total value of the stock of debt owned by central banks and sovereign wealth funds as foreign reserves.

The drawdown of foreign reserves (Figure 3) also reduces the overall level of liquidity in the market.

While the level of reserves remains elevated, the growth in reserves - which had been supporting asset prices - no longer provides the same level of support.

The practical implication of this more challenging liquidity environment is that as market sentiment changes, the impact on asset prices is magnified, leading to increased volatility and price swings.

Given the elevated levels of market uncertainty, we believe that this situation is likely to persist over the next few months until the global economic landscape becomes clearer.

1. Investment grade bonds - The highest quality bonds as assessed by a credit ratings agency. To be deemed investment grade, a bond must have a credit rating of at least BBB (Standard& Poor's) or Baa3 (Moody's).

2. High yield bond - A speculative bond with a credit rating below investment grade. Generally, the higher the risk of default by the bond issuer, the greater the interest or coupon.

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