The Illiquidity Illusion
Financial markets have gone through seismic changes since the global financial crisis, including the passage and continued implementation of both Dodd-Frank and European Market Infrastructure Regulation. These new regulations, geared to increase financial stability and reduce systemic risk, have led to bank consolidation, lower leverage ratios and less use of derivatives and related financing.
While regulators have focused on reducing systemic risk, considering market events of late – including flash crashes and the sudden closure of a high yield bond fund late last year – regulators and investors may be asking if the market liquidity they had assumed to be there was an illusion that has been dispelled. Have we pulled back the curtain to find Oz is just an ordinary man?
The short answer: probably not.
While PIMCO agrees that market conditions have changed from pre-crisis times and there are pockets of diminished market liquidity, we do not believe that conditions are as substantially different as some may perceive. Instead, we think the period of lower volatility when interest rates were near zero and the Federal Reserve seemed to be on hold “forever” has given way to a period of higher volatility due to more uncertain central bank policy.
Additionally, some investors and regulators have concerns about the potential for large liquidations of fixed income assets causing a “run” on mutual funds. We believe this is incorrect for several reasons: First, mutual funds cannot have a true “run” as they are not leveraged entities; they would sell the assets they own and shareholders would receive the value of these assets. Second, asset/fund managers have liquidity buffers and diversification programs to help mitigate these risks. Third, if sales occur across multiple asset managers, it signifies a change in view on an asset class, not a fund-specific issue.
Abrupt changes in valuations are not necessarily liquidity events. For example, if the Fed surprises with a rate rise of 50 basis points (which we do not see as likely), PIMCO would expect prices on most U.S. bonds to fall and bid/ask spreads to initially widen from the surprise. Or if economic data, such as non-farm payrolls, comes out surprisingly weak, equities might re-price lower and fixed income higher. As a result of this news, if investors then start to change their asset allocations out of equities and into fixed income, these assets might change in value violently; bid/ask spreads might widen and volatility might become higher for a period of time.
Two real life examples of such events include the stock market crash of 1987 when equities dropped over 20% and the Swiss National Bank’s sudden decision last year to remove the franc’s peg against the euro, leading to a 20% move in one day. While these market movements were violent and bid/ask spreads widened, they were asset re-pricings ‒ not liquidity events. The market adjusted shortly after these events, liquidity returned and volatility fell.
These examples belie today’s “illiquidity illusion” ‒ this is not a dysfunctional market.
Increasing bid/ask spreads, higher volatility and changes in asset preferences indicate a state of change in market conditions, but not necessarily a lack of liquidity. Investors should be certain to differentiate between volatility and illiquidity, and policymakers should be careful not to misdiagnose the problem they are solving.