FED U-TURN SHOULD PUT LIQUIDITY BACK IN THE SPOTLIGHT / THE FINANCIAL TIMES MARKETS INSIGHT

Fed U-turn should put liquidity back in the spotlight

Investors should remember that return of capital is as important as return on capital

Laurence Fletcher


For much of the past decade, the state of financial market liquidity has been a nagging, but not overly pressing, concern for investors.

Hedge funds have at times grumbled about the difficulty in getting firm prices for corporate bonds from market-making banks. Carrying out bigger bond trades has on occasions proved tricky. But these have been minor problems. Investors have generally been able to buy and sell as they please.

But a bull market covers a multitude of sins. When returns are positive, such complaints seem trivial and it is easier to forget about the potential problems in selling assets down the road. Hedge funds which stopped investors withdrawing their money during the financial crisis seem a dim and distant memory, even though some of those vehicles that tied up investors’ cash are still bouncing round the secondary markets even today.

However, there are now strong indicators that investors should be paying much more attention to how easily and how quickly they can get their money back.

“Liquidity will be seen as the channel from the last crisis to the next one,” said Pascal Blanqué, chief investment officer at funds giant Amundi, which manages €1.47tn in assets. He blames quantitative easing for having pushed down bond yields and forced investors into a “frantic search for yield” in thinly-traded corners of the market.

A number of warning lights have been flashing possible problems ahead. And they have not been limited to junky assets.

In late May last year, for instance, when Italian two-year government bonds posted their worst trading day in decades, fund managers trading the country’s bond market found that it took much longer to unwind positions and found a real lack of buyers for blocks of bonds beyond a certain size.

In December, liquidity in S&P 500 “E-mini” futures contracts tumbled to multiyear lows, which is likely to have exacerbated the market sell-off, according to Deutsche Bank research. Median order-book liquidity for the contracts that month fell across the entire trading day and was at the bottom of its three-year range, says Deutsche.

And even German Bunds, among the most liquid of all assets, got hit. Guillaume Lasserre, chief investment officer at Lyxor Asset Management, reported that one of his portfolio managers had difficulties buying Bunds at the end of last year, such was the demand from other investors wanting to keep them on their balance sheets.

Some of this has been exacerbated by fundamental changes to the structure of the market.

Under pressure from regulators, banks have sharply cut back their market-making activities. Primary dealers’ inventories of corporate bonds have plunged from $285bn in late 2007 to $14bn last month, according to FRB/Amundi research. Meanwhile, the total stock of US corporate bonds outstanding has climbed from $2.8tn to $5.5tn (as of September 2018).

With banks increasingly unwilling to hold bonds on their balance sheets, instead preferring to operate by simply matching buyers and sellers, there are fewer ‘shock absorbers’ in the market when investors need to shift large blocks of bonds. Risk has shifted from the banks to the market.

Meanwhile, another radically-changed market untested by a crisis is the exchange traded fund (ETF) market, which now holds about $4.6tn, according to consultancy ETFGI. Some fear that rapid growth will bring poorer price discovery and increased correlation between investors — a potential danger when everyone tries to rush for the exits at once.

“Market structure and liquidity have changed significantly,” wrote Michael Hintze, founder of hedge fund CQS, in a recent investor letter. “Consequently, we will continue to see lower levels of overall volatility punctuated by gapping markets and rapid mean reversion.”

One further area where investors may find expectations do not meet reality is in Ucits funds. These European-domiciled funds have attracted billions of euros because they are regulated and offer frequent redemptions — at least twice a month but usually daily.

However, last year’s suspension, and then liquidation, of GAM’s Absolute Return Bond funds is a reminder that the assets held in Ucits funds may be harder to get at. Such funds may offer rapid access but also have the power to suspend redemptions — often at the time when investors want their money back most.

Investors now find themselves at a tricky juncture. On the one hand the ending of the European Central Bank’s bond-buying programme appeared to have changed market conditions. Volatility, suppressed by QE for so long, spiked in the fourth quarter, pushing liquidity to the front of minds. On the other hand, the Federal Reserve’s dovish comments last month have calmed volatility, on hopes of easy monetary conditions ahead and potential flexibility in how the Fed unwinds its balance sheet. The good times could continue.

Some investors such as pension funds and insurance companies can afford to lock up assets for years and are in a great position to exploit long-term opportunities in illiquid assets. But for everyone else, the Fed’s U-turn last month offers more time to work out how quickly they can get their money back.