Before the 2008 crisis, even the most esoteric bonds could be sold within seconds, irrespective of market conditions. It now takes seven times as long to liquidate even the most vanilla stuff.
Liquidity was only high because of the implicit subsidy enjoyed by banks that were ‘too big to fail’. That risk has now shifted to buyers and sellers under new regulations on both sides of the Atlantic.
The fragility of the new arrangement became all too evident during the flash crash in the US treasury market in 2014, when securities moved 40 basis points at one point only to reverse just as abruptly. At the time, JPMorgan’s chairman Jamie Dimon described it as an “event that is supposed to happen only once every 3 billion years or so”.
The episode yet again confirmed the age-old paradox: liquidity vanishes when it is most needed.
As the Federal Reserve goes for quantitative tightening, there are growing concerns that a mass exodus of investors may cause a sharp decline in prices and outsized losses for sellers, as the 35-year bull market in bonds comes to an end.
Paradoxically, liquidity is everywhere – look no further than the balance sheets of central banks. Yet dysfunctional imbalances are emerging, especially in two areas.
The first one is esoteric illiquid vehicles that investors have flocked to in search of yield, only to have their fingers burnt. The mass exit from property funds after the Brexit vote is a case in point. Asset managers were forced to suspend redemptions to avoid fire sales.
The second one is reflected in the growing mismatch between the respective assets and liabilities of both retail and institutional investors, as they increasingly demand the daily liquidity that dumbs down their returns.
As markets have plateaued and become more volatile, making money requires exceptional skill or exceptional luck.
Investors worry that the Fed will not be able be able to perform the delicate balancing act of raising rates in 2018 and 2019 (as promised), while keeping a floor under asset values and control volatility. They are yearning for their sugar daddy to stay.
For those of you who subscribe to The Financial Times, my article on liquidity – “Next liquidity crisis could be hiding in plain sight” – is published today (30 April 2018).