More on Liquidity Risk

 A few weeks ago I wrote a piece called “The Looming Crisis” that spoke about the possible liquidity risk on the horizon that was first brought to light by Jamie Dimon in his shareholder letter. In the blog I wrote “Jamie Dimon rattled the financial world with his shareholder letter last week basically saying there exists another crisis looming. He writes, “Treasury markets were quite turbulent in the spring and summer of 2013, when the Fed hinted that it soon would slow its asset purchases. Then on one day, October 15, 2014, Treasury securities moved 40 basis points, statistically 7 to 8 standard deviations – an unprecedented move – an event that is supposed to happen only once in every 3 billion years or so (the Treasury market has only been around for 200 years or so – of course, this should make you question statistics to begin with). Some currencies recently have had similar large moves. Importantly, Treasuries and major country currencies are considered the most standardized and liquid financial instruments in the world. The good news is that almost no one was significantly hurt by this, which does show good resilience in the system. But this happened in what we still would consider a fairly benign environment. If it were to happen in a stressed environment, it could have far worse consequences.””

Since then I have seen many market experts coming out to reiterate and confirm such fears.

Mar. 25, 2015 - HOWARD MARKS: Liquidity is not how easily you can sell something – Business Insider: “Marks' note comes on the heels of this report from the Financial Times on Monday, which cited a number of investors in the bond market who are worried about a potential liquidity crunch in markets.”

Apr. 15, 2015- FED OFFICIAL: We risk a market bubble if we don't move on monetary policy – Reuters (via Business Insider): “"A risk of remaining at the zero lower bound too long is that a significant asset market bubble will develop,” St. Louis Federal Reserve Bank President James Bullard said in prepared remarks.”

Apr. 15, 2015 - STAN DRUCKENMILLER: I just know this is going to end badly; I can feel it in my bones – Business Insider: “Druckenmiller, 61, accurately called the housing crisis. During his speech, he said that he has the same horrific feeling now as he did back then.”

Apr. 15, 2015  Marc Faber says Short Central Banks and Buy Gold – Marc Faber Blog: “I think that my bet is that if i could short central banks i would short central banks in 2015 because I think that investors will suddenly realise what a scam central banking is and then they will lose confidence. And there is only one way to short central banks and that is to buy gold.”

Apr. 20, 2015 - The IMF's scary warning about the bond market might not be scary enough – Business Insider: “One word is starting to come up over and over again in markets: liquidity. On Sunday, Business Insider's David Scutt wrote about a recent report from the IMF that warned about the risks of market liquidity disappearing in times of financial stress, exacerbating market reaction to certain events.”

Mile wide, inch deep - Bond market liquidity dries up – Ben Eisen on liquidity risk: “These market shifts are set against the backdrop of a widespread fear that investors will leave the bond markets en masse as interest rates rise”

Apr. 20, 2015 - Half a Bubble Off Dead Center - John Mauldin: “My dad used to say about a situation that just didn’t seem quite right that things were “about a half a bubble off dead center.” (This was back in the days when we used bubble levels to determine whether something was level or plumb – before today’s fancy digital gadgets.) There is a reason, I think, that everything seems just a little out of kilter. I believe that central banks, in their valiant, unceasing efforts to restore liquidity and growth, have unleashed numerous unintended consequences that are beginning to show up in earnest.”

Apr. 22, 2015 - Bank of Mexico Governor sees 'asset bubbles' and the 'illusion of liquidity' – Business Insider: “Given the magnitude of the crisis, “unconventional monetary policies have been essential and have worked so far,” he said, toeing the line. But “it’s too early to declare victory.” We “still have to see if the unwinding of those policies can proceed in an orderly fashion.” But even if the unwinding is not orderly, it’s “unavoidable.” Otherwise, they’d “feed into inflation and induce higher than warranted interest rates and financial instability.””

Apr. 23, 2015 - The Fed is trying to avoid a 'nightmare scenario' – Business Insider: “(Reuters) - Sections of the U.S. financial system that may be vulnerable to investor panic are raising concerns inside the Federal Reserve, as policymakers preparing for the first interest-rate hike in nearly a decade seek to ensure that the market is ready and able to handle it whenever it happens. The Fed is particularly worried about whether the booming asset management industry can withstand a run of redemptions in a financial crisis.”

Apr. 23, 2015 - Here's why money managers pose a systemic risk – Business Insider: “As stock markets move to new highs, asset managers are booming, with vast inflows into bond and equity funds alike. The IMF has pointed out the potentially systemic risks created by concentrated pools of inflated and increasingly correlated assets. It is now time for regulators around the world to recognize the risks inherent in asset managers and funds that are too big to fail.”

Apr. 24, 2015 - The Next Bubble Is A Matter of If Not When – Fox Business: “Many analysts believe the Fed’s so-called ‘easy money’ policies initiated in the wake of the 2008 financial crisis have helped push U.S. stock indexes to new records and bond prices to their highest levels in decades. “By manipulating interest rates the Fed creates circumstances that lead to an expansion in the financial markets that ultimately has to contract,” said Roberts. “In other words we get these booms and busts.””

Apr. 26, 2015 - The market is getting nervous about something experts are struggling to define – Business Insider: “Since the bond market's "flash crash" back in October — when US 10-year Treasury yields fell 34 basis points, or 0.34% in one morning — concerns regarding liquidity and how resilient the bond market might be to shocks have lingered around the market. In the Minutes from the Fed's January policy meeting, we noted that the Fed was clearly starting to worry about liquidity.”

I am not one to fear monger but as I wrote in the blog two weeks ago, there does seem to be some market distortions that have led to an over-valued situation. While I can’t be sure, my initial assumption is that these distortions have been created by unprecedented and unorthodox monetary policy that has been initiated since the great recession. Should there be a mass run for the exits, the liquidity environment could accentuate losses in one’s portfolio.

Just something to keep an eye on.

Joseph S. Kalinowski, CFA

 

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