To paraphrase Oscar Wilde, a pessimist would say investors know the price of everything and the value of nothing. But the sensibility could be much worse because they may not even know the price.
For decades, investors and policymakers have accepted financial market prices as the critical gauge for the overall outlook on the economy and market performance. Some recognise that markets can become carried away as bubble dynamics develop, and since the 2008 financial crisis a veritable industry has evolved, seeking to single out the next bubble to pop.
Not a day passes by without Cassandras’ calling for the impending crash in China under a volcano of debt, or the break-up of the Eurozone or America’s corporate balance sheets buckling under years of excessive debt issuance.
Yet, through all of this, the faith in the market price has persisted. Most don’t dispute whether the basic formation of market prices is erroneous.
But what if market gyrations are less to do with moves in forecasts on the economy or company performance, and more to do with players coming to terms with a less efficient market?
The preceding few months have provided us with clear glimpses of this.
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The harshest was seen in currency markets at the start of the year. The Japanese yen experienced a flash-crash when it jumped 4 percent against the US dollar in one day. This was indeed more remarkable because the cause was apparent selling of an emerging market currency against the yen, which ended up influencing the trillion-dollar-a-day yen market.
The final month of 2018 saw markets suffer extreme moves in the absence of much fundamental news. At one point US equities were down over 15 percent, before reversing those losses over the subsequent weeks.
Interest-rate markets swung from the prospect of advances in Fed policy rates for 2019 to reductions. All the actions, from currencies to equities to interest rates, were more likely precipitated by liquidity problems than deviations in underlying elements or credit risk.
So what has produced this growing fragility?
Three elements stand out. First, the growth of electronic trading on both the sell side and buy side, with robots replacing human market makers to produce endless torrents of prices. Buying and selling securities can be performed at the click of a button.
Not simply that, but entities that never made markets in securities can now plug into the streaming prices of a greater liquidity provider and determine them as their own. The chimaera of those prices and the elaboration of market makers provide the illusion of satisfactory market liquidity.
Second, it has lessened the role of banks in the market-making process. Thanks to the scars of the 2008 financial crisis, poor behaviour of traders and strengthened controls, banks have been squeezed.
In the past, they could hold securities if they could not spot a purchaser in the market, but now with balance-sheet constraints, they have to sell into thin markets, which could exacerbate price gyrations.
Third, the conspicuous presence of central banks in financial markets after their large-scale quantitative easing programmes has established a
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credible buyer of last resort. This has made market players believe they can sell more freely than they actually can.
The result is that in “normal” times, liquidity (or the capacity to buy or sell a security) appears ample. Investors have endless prices flashing before them, there is no need to communicate with another human and central banks will always intervene if obliged to.
However, when “extraordinary” times hit, this liquidity can dissipate. The streaming prices stop as the robots freeze; human traders are inhibited to act, and central banks are slow to buy or have shifted policy to avoid serving as a buyer of last resort.
Today’s biggest risk could be that investors are underpricing liquidity risk. They assume their assets are worth one thing when they study movements of prices, but they may be worth another when they try to sell them.
It further means that extreme market movements could be less reflective of the credit or business cycle and more reflective of this repricing of liquidity. All providing new challenges to central banks as they undo their easing programmes. Thus, it may now be time to add another worry to the list: the unravelling of the market liquidity illusion.