Thursday, 4 June 2015

Liquidity - The market is not a third party price guarantee system.

I first made most of these comments on liquidity 8 months ago, but with so much comment flying around after recent bond price falls all highlighting the dangers of no liquidity I feel it essential to raise them again.

There is a lot of concern, correctly, that liquidity in some markets is so dire it could lead to some serious meltdowns. Eyes were on High Yield via the energy sector but are now on bonds in general, especially after some deservedly sharp Bund moves and Mr Draghi's comments that we should get used to bond volatility.  But should we be concerned about a meltdown caused by low liquidity? The normal response is "Yes of course! Prices will collapse and there will be high volatility and and and" but am I allowed to ask “So what? Does that matter?"

Before we go any further it is worth refocusing our minds on what a market is. Though the world is used to seeing tight prices flash upon their screens and have come to expect to be able to deal on those in an instance let us remind ourselves that a market is a meeting place of willing buyers and willing sellers. It is not a third party price guarantee system.

If there is a meltdown in an asset it's triggered by a lack of people wanting to buy normally associated with an adjustment in perceived value (though the first waves of a bubble burst are more associated with everyone being fully leveraged owners incapable of raising more funds to buy). When there is no liquidity (buyers) prices pass through where people think fair price sits (otherwise they wouldn’t be moaning of no liquidity) to prices which they feel are unfair or downright silly and don't reflect actual probabilities of default or yield outcome. Which begs the question "why are they selling at values that they think are absurd and moaning that it's due to lack of liquidity?".

It can all be boiled down to money management rules creating large gaps between actual outcome probabilities and priced probabilities. This is particularly true in systems that use price as an input of probability in the first place, as we saw with CDS prices being quoted, wrongly, as actual probabilities during the EU crisis. So we could argue that any huge swings in pricing caused by a lack of liquidity will punish those who have to employ short term money management rules over those that can take a sanguine long term view. So rather than all being bad, it creates opportunity and acts as feedback hopefully moving fund management away from the, sometimes cretinous, short term consultants' tight risk rules back towards a more balanced macro big picture value view.

But what about the losses? Well if the true price that reflects future outcomes has indeed moved then tough. That is nothing to do with liquidity and is to do with a step change in value due to changing information and is a fundamental investment risk. The fact that the price has stepped, rather than glided down giving you a chance to exit at a better price, is because the market is pricing information efficiently and does not owe you any favours.

For those being forced to sell below where they see as the real price, due to no liquidity, their loss must be someone else’s gain as those selling must be selling to someone else who is picking up a bargain. So the negatives due to bad liquidity are offset by someone else’s positives.

So if there is to be a bond meltdown due to a new reality then fair enough, the information about supply and inflation is there for everyone to see. But if it is due to poor liquidity with no large change in fundamentals then I look forward to buying some at stupidly low levels caused by some VaR calculation that pulls upon volatility as it's major risk measure saying 'spew at any cost'. Thank you.

The wealth destruction argument is different. If leverage is involved, which of course it is, then book values will tank and no doubt the value of that book has been used to borrow to fund some other asset, which then has to be sold. That is the transmission risk to other asset classes and in the case of bonds doubly so due to their price directly feeding back to the cost of all leverage. But once again that isn't a liquidity problem, it's a mispricing problem and the inability to wear deviations from reality due to the constraints of leverage or irrational performance benchmarking.

It's not liquidity that is the problem, it's once again leverage.

Finally, as a follow up to the Bund collapse, I wonder how the JPM Asset Management head of rates is getting on after his "why we are buying -ve yield" comments in February Pensions must be screaming.


theta said...

Very good post, and nicely summarised at the end: It's not liquidity that is the problem, it's once again leverage.

The most interesting point is the last one, about wealth destruction. Beyond the zero sum game of positions changing hands at the wrong prices, what are the potentially negative consequenses for even "innocent" players from overall wealth destruction /recession. In the last episode, the hugely overlevered home-"owners" went rightly bust, but along with them the next few tranches as well, plus the whole economy took a dive. Stupid banks fell but even more solid ones took a hit as contagion can be huge. This time it seems that these sectors are fine, but corporate debt is a bit worrying. Could that expose vulnerabilities elsewhere in the system?

hipper said...

Excellent post. So I guess it's good to be aware when there really is a change in the fundamental information which implies changes in potential real future yields, vs. when the price change is driven by unrelated liquidity events. Which currently might be perceived to be the case as leverage trade brakes down resulting from an external driver, which is transforming into a self-sustaining loop as a cause of the collateral book value going into a descending spiral resulting in further forced withdrawal of leverage which has been used to buy that same underlying asset. So maybe, in the bond space, the external driver this time indeed resulted from a real fundamental change in inflation expectations but because of the leverage interconnected liquidity has appeared as very erratic price movements. So maybe the fundamentals are really changing but the price is just unable to express it in a tranquil manner because of the leverage effects being in nature very unstable.

But it really might not be such a one sided negative, if it provides an opportunity to obtain equity coupons with better FCF yields with unchanged fundamental data then it might be regarded more as a gift landing from the heavens. Extraordinary liquidity effects having extraordinarily large short term price effects such as this one, provided that they are taken advantage off might dramatically increase future yield expectations.

Re equities I wonder if we're already in the stage where there is really no more rotation from "expensive to cheap" markets. There are lots of (fundamentally) cheaper options than spoos, but if spoos start backing up will it drag all the seemingly cheapy EM's with it anyway rather than rotate? Whether bonds keep falling of course is probably an important factor, hard to see how spoos with the 1.9% average DY and stagnating sales figures is going to ignore bond yields for too long.

Polemic said...

Thanks Theta and Hipper, my friends.

Good points