As stocks and bonds remain under pressure, traders,
market makers and central banks are seeing signs of lower liquidity and increased risk of
market gyrations.
Trading conditions in equities and bonds have deteriorated as
money managers find it increasingly difficult to buy and sell in size. Liquidity in
S&P 500 futures is concerning even when comparing with the 2020 Covid meltdown in the
stock market.
“Market depth is not much better than it was during March 2020,”
JPMorgan strategist Nikolaos Panigirtzoglou wrote in an email seen by Bloomberg. “This
implies that the ability of markets to absorb relatively large orders without
significantly impacting the price is very low at the moment.”
This year has been notable for cross-asset correlation as stocks,
corporate credit and government bonds have been sold off. This reflects fears the Federal
Reserve’s plan to embark on quantitative tightening and raising rates will reduce the
availability of liquidity.
May saw the S&P 500 dip into bear market territory briefly.
Its sister index the Nasdaq remains well in a bear market – defined as down 20% from its
peak – as tech stocks have borne the brunt of the rise in bond yields following the
Federal Reserve’s pivot to a more hawkish stance. Whether lower asset values and higher
volatility is leading to lower liquidity, or the reverse is true, bear markets are marked
out as periods of lower liquidity. This is in sharp contrast with the vast liquidity
pumped into the market by the Fed’s QE programmes during the structural bull market of the
last ten years. In some ways, it could be argued that bull and bear markets are functions
of market liquidity, just as inflation is a function of the supply of money compared with
output.
And the Fed has noticed things are not great, using its latest
Financial Stability Report to warn of the systemic risks posed by declining liquidity.
“According to some measures, market liquidity has declined since
late 2021 in the markets for recently-issued U.S. cash Treasury securities and for equity
index futures,” the Fed stated.
“While the recent deterioration in liquidity has not been as
extreme as in some past episodes, the risk of a sudden significant deterioration appears
higher than normal,” the report said. “In addition, since the Russian invasion of Ukraine,
liquidity has been somewhat strained at times in oil futures markets, while markets for
some other affected commodities have been subject to notable dysfunction.”
This echoes the warning earlier this year, due following
significant dislocation in energy markets, from the European Federation of Energy Traders,
which called on central banks and governments to provide “emergency liquidity support”.
The body warned that many were in a “position where their ability to source additional
liquidity is severely reduced or, in some cases, exhausted”, and it stressed that
“generally sound and healthy energy companies” might be “unable to access cash”.
Low liquidity is typical of a structural bear market. Whether we
are in a structural bear market or not is up for some debate, but it seems likely. The
ample liquidity provided by central bank quantitative easing is over.
This is a particular problem for the bond market. Regulatory
constraints on banks’ leverage since the financial crisis means they are less able to hold
sufficient Treasury inventories. This has seldom been a problem as the Federal Reserve has
been very active in buying US government debt. But with the Fed no longer the buyer of
last resort, there is greater risk of wider bid-ask spreads and thinner liquidity. Market
depth has declined and was deteriorating before the Russia-Ukraine conflict. In early
March, several indicators on JPMorgan’s Liquidity Stress Dashboard were flashing red.
According to Goldman Sachs, market depth and price impact metrics are closer to levels
last seen during the Covid shock, “suggesting fairly high risk of disorderly price
action”.
The Fed’s data indicates there are several reasons for the lower
liquidity, not just the bank’s own monetary policy shift.
“Quoted depth has decreased since late 2021 for the interdealer
U.S. Treasury securities, S&P 500 E-mini futures, and West Texas Intermediate crude
oil futures markets,” the report said.
“Initially, in Treasury and equity markets, the decline in depth
reflected rising uncertainty about the outlook for monetary policy; in the Treasury
market, the decreases in depth were greatest for bonds with shorter maturities because the
prices of those securities are more sensitive to expectations for monetary policy over the
near term. In oil markets, depth has declined particularly sharply in recent months as a
result of the elevated level of uncertainty and volatility associated with the Russian
invasion of Ukraine.”
Spreads
The good news for traders is that while depth has been low,
bid-ask spreads paint a slightly different picture, as they remain more stable in the most
liquid markets. Average bid-ask spreads in the most liquid Treasury and equity markets
have increased only slightly above their typical levels.
“These mild increases suggest that, though liquidity providers
have been less willing to quote in large size, they have replenished quotes sufficiently
quickly to meet incoming orders without exhausting all quotes at the best prices,” the Fed
report states. “Depleting the best quotes would have caused bid-ask spreads to widen until
new quotes at narrower spreads were posted subsequently. Moreover, at least some market
participants may have been able to split trades into smaller transaction sizes to avoid
exhausting all the quotes available at the best prices.”
However, bid-ask spreads in some other markets increased more
notably before partially falling back, such as in oil futures.
Hard to predict
It is difficult to predict periods of extreme market illiquidity.
While recent low depth in the most liquid Treasury and equity markets has not been
accompanied by extremely high and volatile bid-ask spreads, that situation could change if
liquidity providers were to slow or stop replenishing quotes in response to incoming
orders.
However, as with two recent episodes of low market depth in
August 2019 and March 2020, it is difficult to predict whether market liquidity would
deteriorate in this way.
For example, if we look at bid-ask spreads for the 10-year
Treasury, quoted depth decreased rapidly from late February to early March 2020. Bid-ask
spreads stayed low and stable until early March but then increased dramatically in
mid-March after some liquidity providers scaled down their market-making activity. In
contrast, in August 2019, we saw a prolonged period of low depth which was not followed by
heightened bid-ask spreads.
Cause for concern?
Quoted depth is currently low in Treasury, equity, and oil
markets, but there have been no reports of severe market functioning problems, says the
Fed, which adds that the effect on trading costs for many investors has probably been
limited.
“However, the low level of depth means that liquidity provision
remains fragile due to heavier reliance on sufficiently rapid quote replenishment to meet
trading demands without resulting in sharp price moves,” the report’s section on liquidity
concludes. “This dependence on higher-velocity quote replenishment when depth is low could
pose an important vulnerability in these markets, as it suggests that there is a
higher-than-normal risk that a significant deterioration in liquidity provision could make
prices even more volatile and lead to market dysfunction.”
The great unknown for market participants is what happens when
the Fed starts reducing its balance sheet through QT. Whilst there may not be a sharp
decline in asset prices, many believe QT could lead to a significant effect on the cost of
liquidity.