On 15 October 2014, the yield on the benchmark 10-year US Treasury note plunged from 2.02% to 1.86%, an event that was meant to occur only once every 3.5 billion years according to Jamie Dimon, CEO of JPMorgan, speaking at the time.
The culprit was weaker than expected US retail data. However, as the markets recovered, the event was seen as a blip like other big liquidity episodes in this decade – until the current travails at Woodford Asset Management.
Once again, they reveal that liquidity risk is often overlooked in asset allocation. Not all assets can be quickly bought or sold in the market without affecting their price at a given time, contrary to the tenet of Modern Portfolio Theory.
To compound the problem, easy money policies of central banks have reinforced the illusion that liquidity will always be there while the global economy is awash with cash.
The Woodford saga is not unique. When the US Federal Reserve first announced its decision to taper its ultra-loose monetary policy in 2013, liquidity in emerging markets suddenly vanished.
Dubbed the ‘taper tantrum’, that episode witnessed a large-scale fire-sale of EM assets and currencies. Stop-loss devices, designed to minimise the pain, failed as investors herded towards the exit. No amount of regulatory intervention could have stopped them.
It also showed that providing liquidity in times of crisis can reap handsome returns, following Warren Buffet’s credo: buy in periods of panic selling.
Caution flags now flutter in the background. The further we advance in the current market cycle – the longest in history – the more unreal asset valuations will become and the more fragile investor sentiment will be. Liquidity tensions will intensify future corrections when the cycle turns into a recession. Dovish policies by central banks will not help much once investors become fearful.
I have given further details in an FTfm article published earlier this week (5th August 2019). If you are a subscriber, you can read it here.