By John Geddie
LONDON (Reuters) – Investors used to thinking that vast quantities of cheap central bank money make financial assets a one-way bet have had a rude awakening in recent weeks, as that same conventional wisdom created frailties in the functioning of markets.
The latest correction may look little more than a blip in a eight-year rally. But it has exposed a painful truth about an essential issue – liquidity.
Global central banks have pumped $11 trillion into the economy since 2007. That abundance of cash has made it harder for investors to sell their financial assets without triggering wild price swings.
The flood of liquidity helped drive asset prices to record levels. It also convinced investors that prices, in both safe-haven bonds and riskier equities, would keep rising.
The problem is that liquid markets by definition need to work both ways, and increasingly investors find themselves all heading the same way. Markets have become, in the jargon, illiquid.
“You are getting surprisingly large price moves on very little news, and everyone is increasingly conscious that the underlying cause is herding,” said Citi strategist Matt King. “These markets that trend strongly are prone to abrupt reversals almost without cause.”
For those invested in the more esoteric or high-risk assets, like junk bonds and emerging-market currencies, liquidity has never been taken for granted. Price volatility is commonplace.
Now the sell-off that began in euro zone bonds last month is showing just how vulnerable perceived safe investments can be.
Analysts have struggled to pin down the exact trigger for the turnaround, but top-rated German bond markets – where yields are negligible and investors have strict loss limits – were at the epicenter of the shock.
JPMorgan said one consequence of central bank largesse is that investors assume it ushers in a period of calm on financial markets. They apply ‘value-at-risk’ models that encourage them to increase the size of their positions to reflect the low volatility.
In the main, this has worked But the proliferation of the models means that when sentiment changes and everyone heads for the exit at the same time, the results can be brutal.
In October 2014, speculative “shorts” — bets U.S. Treasury bond prices would fall — reached record levels, just before markets swung sharply in the other direction, data from CFTC, a U.S. government agency that monitors futures markets, showed
Three weeks ago, in Europe, the opposite happened. Investors though a 1 trillion-euro central bank bond-buying program that began in March would push yields ever closer to zero. But German 10-year yields have since jumped from a record low 0.05 percent in mid-April to a 2015 high of 0.80 percent.
“The extent of some of these intraday moves has been enormous,” said Andrew Balls, head of European portfolio management at PIMCO, who oversees a team managing $400 billion.
“It looks like a symptom of a market where there’s less liquidity, so you get these very significant moves.”
JPMorgan estimated one investor could have traded 100 contracts of 30-year Bund futures <FGBXc1=> in early 2014 without moving the market significantly. Now that number has fallen to 20 contracts. Thirty-year Bund futures have plunged about 24 points, or 2,400 ticks, in the past three weeks.
The liquidity drought and increased volatility may have done permanent damage to what was once considered a rock-solid asset.
“I think it is a fundamental change. I don’t think we’ll go down to those levels again, because everyone’s learned their lesson now,” said Sandra Holdsworth, and investment manager at Kames Capital.
(Additional reporting by Marius Zaharia and Jamie McGeever; Editing by Larry King)