March 30th, 2016 | By Nick Sargen
Throughout the post-war era U.S. financial markets were the deepest and most liquid in the world, which gave investors the ability to enter and exit positions at low cost. However, in the run-up to the 2008 financial crisis transactions costs increased in fixed income markets. This development was first evident in trading of non-agency mortgage-backed securities and structured products, where the process of price discovery broke down. Illiquidity then spread to the corporate bond market, first to high yield bonds and eventually to investment grade bonds. It became extreme during the crisis period when attempts to sell bonds resulted in steep price declines.
For a while, investors believed the increased illiquidity would be temporary. However, it has persisted after economic conditions stabilized; consequently, they have no choice but to adapt to the new circumstances. One reason is that legislation such as the Dodd-Frank Act in 2010 makes it less profitable for dealmakers to hold large inventories of bonds. Deal-making activity in the bond market has shrunk across the spectrum, and illiquidity has been particularly evident since last summer, when credit spreads versus treasuries widened materially.
At the same time, unorthodox monetary policies by the Federal Reserve and other central banks have introduced distortions into capital markets. As central banks conduct monetary policy by purchasing large quantities of government bonds and other safe assets that drive short-term rates to zero or negative, they have encouraged private institutions to hold assets that are riskier and less liquid than government securities.
Lawrence Goodman, President of the Center for Financial Stability contends that these policies have contributed to “crowded trades” and market distortions. (See Goodman’s speech to The Boston Economic Club on March 23.) According to Goodman, data compiled by his institution show that the availability of market finance is more than 30% below a reasonable level to support liquid markets. In these circumstances, even minor disturbances that cause investors to sell positions can unleash a cascade of price changes and lead to an evaporation of market liquidity. Examples he cites include the Treasury flash crash, vanishing prices in trading of currencies, and illiquidity in corporate bonds.
Several examples were highlighted at the ACLI conference and Mayo Center Roundtable including large gyrations in oil prices in the past two years and the impact that a modest devaluation in China’s currency had on financial markets since August of last year.
Mark Viviano, a Managing Director and energy portfolio manager for Wellington Management, began his remarks at the ACLI conference by polling the attendees about how much excess supply there was in the oil markets, with the consensus being 10%-20%. He then showed that official statistics indicate the excess supply, in fact, is only 1%-2% of total production, and at most 5% if inventories held in tankers are included. The central issue he addressed is why an industry operating at 95% of capacity should see price declines of 70%.
Viviano’s explanation is that the decision by Saudi Arabia in November of 2014 to abandon its former role as the residual supplier of oil in favor of allowing market forces to set prices caused a sea change in expectations among energy producers and investors. Whereas they previously viewed oil as being stable around $100 per barrel, they subsequently realized the Saudis wished to see prices fall to a level that would drive marginal shale oil producers out of business. For a while industry experts believed a price in the vicinity of $40-$60 per barrel would be sufficient. However, when shale oil production proved to be more resilient than expected, another round of price declines ensued, with prices at one point falling below $30 per barrel, a level that is considered well below the long-run equilibrium price.
This development, in turn, fueled expectations of widespread defaults for high yield bonds in the energy space, which spilled over to other sectors. When credit spreads versus treasuries reached levels in past recessions, some investors concluded the bond market was pricing in a recession. However, this may not be the case, because the widening in spreads reflected increased illiquidity in the bond market, as well as concerns about increased defaults, and it is not easy to separate the two effects.
Just when investors feared that prices could fall further to $20 or even lower, the Saudis signaled they would refrain from increasing production in an effort to establish a floor for prices. This has been sufficient to calm investor fears recently, and Viviano is optimistic prices will recover further to the $50-$60 range once there is evidence that marginal producers are cutting back on production. It is an empirical question, however, how long this will take.
Worries about China’s Currency
Another example cited at the Mayo Center Roundtable was the sea change in expectations that occurred last August, when the Chinese authorities announced the yuan would fluctuate in a wider band against the dollar, and the Chinese currency depreciated by 2%-3%. The move contributed in a sell-off in world markets, as investors believed the Chinese authorities were risking the start of a “currency war.” When the authorities subsequently announced in December they would henceforth link the yuan to a basket of currencies, market participants focused on capital flight from China, as the country’s foreign exchange reserves fell by about $700 billion from the peak level of $4 trillion.
However, Professor Frank Warnock of the Darden School, who recently returned from China, noted there was an alternative explanation to the decline in China’s reserves. He pointed out that during the investment boom after 2008 many Chinese businesses financed their operations by borrowing in U.S. dollars, because they expected the dollar to continue to depreciate steadily against the yuan. When the yuan began to weaken against the dollar last summer, they began to pay down their dollar-denominated debt. While such actions are equivalent to capital outflows, the motives are not the same as ones associated with capital flight. In Warnock’s view, the current situation is desirable because China’s currency no longer is viewed as a “one way” bet.
One of the main takeaways is that market liquidity is not likely to improve anytime soon, and “crowded trades” may have become a fixture of the investment landscape. The reason: Increased regulation of financial institutions and unorthodox monetary policies – including negative interest rate policies in Europe and Japan – are not going away. According to Richard Mayo the policies of central banks pose a major challenge for investors, because it is unclear what the appropriate risk-free rate is that should be used to discount future cash flows.
In these circumstances, investors need to be cognizant of how to allocate assets between those that are liquid and those that are not. They also must ascertain whether positions they hold are “crowded trades,” where investment performance can shift quickly and selling pressures beget illiquidity. This situation is not entirely bad, as market dislocations can present investors with buying opportunities. However, it means that investors no longer can take market liquidity for granted, and they may have to be more tactical in positioning investment portfolios.