In a survey of 400 senior investment decision-makers at institutional investors in Australia, China, Germany, Japan, the UK and the US with a combined assets under management (AUM) of >US$12 trillion the tail-risk scenario seen as having the greatest market impact and one for which they are least prepared is a major liquidity event in financial markets, according to investment manage PGIM.
The results follow consistent quantitative declines in liquidity quality within fixed income measured by trading volumes and bid-ask spreads, liquidity events including the March 2020 sell off and the September 2022 Gilt crisis, and qualitative reports of market makers pulling back from secondary markets.
Greg Peters, managing director, at PGIM Fixed Income says, “The moment in which one loses confidence in the very instrument that defines risk-free, the ripple effect is massive.”
The report notes that for those investors who were around for the global financial crisis or the ‘Taper Tantrum’ of 2013 in which the Federal Reserve reduced buying activity; “it should come as no surprise that a liquidity event is top of mind for CIOs. A sudden drying up of liquidity in some of the most fluid markets in the world can create terrifying moments for investors.”
Some of the reasons include the size of the bond market in 2021 as measured by total debt outstanding being estimated at US$119 trillion worldwide, and US$46 trillion for the US market, according to the Securities Industry and Financial Markets Association.
Parallels are drawn between that crisis and last decade’s Taper Tantrum and today’s environment. Sudden directional pressure, as seen in the Fed’s announcement of its intent to rein in its quantitative easing program in 2013, and the COVID and oil-war induced “dash for cash” in early 2020 can drive global selling pressure was across sovereign bond markets, “resulting in a deterioration in market functioning of key asset markets, which in turn led to central bank interventions.”
The report cites research from the New York Federal Reserve that selling pressure was more pronounced and broad based in US Treasuries than in other sovereign bond markets, “reflecting the US dollar’s role as the dominant global investment and funding currency.” But also notes leverage can amplify liquidity turbulence, cited by the Fed in explaining why the Treasury market faced larger disruptions to market functioning.
“Stronger pre-pandemic Treasury issuance, as well as supportive financing conditions and other factors, helped pave the way for a heavier build-up of leverage in the Treasury market than in other sovereign bond markets,” the bank’s researchers concluded. “As a result, the COVID-19 shock catalysed more de-leveraging, and hence higher selling pressure, in the Treasury market.”
A liquidity crunch in UK gilts in 2022 is also cited as a recent event, as it prompted the Bank of England to intervene with a pledge to buy government bonds to calm the market. It showed leveraged pension funds were forced to sell assets to post additional collateral further drying up liquidity in the system in a market spiral.
The Fed’s ratcheting back of ‘easy money’ while raising rates has resulted in “a marked increase in volatility, sharply higher bond yields, and growing concern about how it all ends. Were it to happen, a severe liquidity crisis in arguably the world’s most important market (US Treasuries) would have a cascading, ripple effect across global markets,” the report notes. “Treasuries are the backbone of the international financial system, widely held by foreign central banks and the gauge off of which rates on many loans are set.”
It warns that a reduction in global liquidity could pave the way for disruptions in the “proper behaviour of financial markets and, in the worst cases, suppress investor risk appetite to the point it leads to malfunctioning markets.”
“What’s more, one of the sinister developments of such a scenario is that there would be very few places to hide; even during market-jolting events such as the Russia-Ukraine military conflict, there were corners of the market where investors could find returns, whether it be in energy and other commodities, gold or fixed income,” it writes. “But when global liquidity evaporates, there are very few ports in the storm. One of those ports would typically be US Treasuries, so a liquidity event there — unlikely as it seems — would be devastating. The cascading effects would bleed into assets that investors have moved into heavily and would likely involve counterparty risks. Neither capital providers nor investors would necessarily be prepared for that.”
One large US investor, surveyed for the report, said, “Think about Long-Term Capital, when you employ a handful of people that have Nobel Prizes and PhDs — the smartest people on the planet — and their whole idea was to pick up pennies off the floor. It would add up to a really nice return. Then a handful of bad circumstances all lined up together in a once-in-a-lifetime event and it took the company down and shook up some pretty large counterparties.”
©Markets Media Europe 2023
