NEW YORK (Project Syndicate) — A paradox has emerged in the financial markets of the advanced economies since the 2008 global financial crisis. Unconventional monetary policies have created a massive overhang of liquidity. But a series of recent shocks suggests that macro liquidity has become linked with severe market illiquidity.
Policy interest rates are near zero (and sometimes below it) in most advanced economies, and the monetary base (money created by central banks in the form of cash and liquid commercial-bank reserves) has soared — doubling, tripling, and, in the United States, quadrupling relative to the pre-crisis period.
This has kept short- and long-term interest rates low (and even negative in some cases, such as Europe and Japan), reduced the volatility of bond markets, and lifted many asset prices (including equities, real estate, and fixed-income private- and public-sector bonds).
This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices.
And yet investors have reason to be concerned. Their fears started with the “flash crash” of May 2010, when, in a matter of 30 minutes, major U.S. stock indices fell by almost 10%, before recovering rapidly. Then came the “taper tantrum” in the spring of 2013, when U.S. long-term interest rates shot up by 100 basis points after then-Fed Chairman Ben Bernanke hinted at an end to the Fed’s monthly purchases of long-term securities.
Likewise, in October 2014, U.S. Treasury yields plummeted by almost 40 basis points in minutes, which statisticians argue should occur only once in three billion years. The latest episode came just last month, when, in the space of a few days, 10-year German bond yields went from five basis points to almost 80.
These events have fueled fears that, even very deep and liquid markets — such as U.S. stocks and government bonds in the U.S. and Germany — may not be liquid enough. So what accounts for the combination of macro liquidity and market illiquidity?
For starters, in equity markets, high-frequency traders (HFTs), who use algorithmic computer programs to follow market trends, account for a larger share of transactions. This creates, no surprise, herding behavior. Indeed, trading in the U.S. nowadays is concentrated at the beginning and the last hour of the trading day, when HFTs are most active; for the rest of the day, markets are illiquid, with few transactions.
A second cause lies in the fact that fixed-income assets — such as government, corporate, and emerging-market bonds — are not traded in more liquid exchanges, as stocks are. Instead, they are traded mostly over the counter in illiquid markets.
Third, not only is fixed income more illiquid, but now most of these instruments — which have grown enormously in number, owing to the mushrooming issuance of private and public debts before and after the financial crisis — are held in open-ended funds that allow investors to exit overnight. Imagine a bank that invests in illiquid assets but allows depositors to redeem their cash overnight: if a run on these funds occurs, the need to sell the illiquid assets can push their price very low very fast, in what is effectively a fire sale.
Fourth, before the 2008 crisis, banks were market makers in fixed-income instruments. They held large inventories of these assets, thus providing liquidity and smoothing excess price volatility. But, with new regulations punishing such trading (via higher capital charges), banks and other financial institutions have reduced their market-making activity. So, in times of surprise that move bond prices and yields, the banks are not present to act as stabilizers.
In short, though central banks’ creation of macro liquidity may keep bond yields low and reduce volatility, it has also led to crowded trades (herding on market trends, exacerbated by HFTs) and more investment in illiquid bond funds, while tighter regulation means that market makers are missing in action.
As a result, when surprises occur — for example, the Fed signals an earlier-than-expected exit from zero interest rates, oil prices spike, or eurozone growth starts to pick up — the re-rating of stocks and especially bonds can be abrupt and dramatic: everyone caught in the same crowded trades needs to get out fast. Herding in the opposite direction occurs, but, because many investments are in illiquid funds and the traditional market makers who smoothed volatility are nowhere to be found, the sellers are forced into fire sales.
This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into overvalued, increasingly illiquid assets — such as bonds — the risk of a long-term crash increases.
This is the paradoxical result of the policy response to the financial crisis. Macro liquidity is feeding booms and bubbles; but market illiquidity will eventually trigger a bust and collapse.
This article has been published with the permission of Project Syndicate — The Liquidity Time Bomb.
Shiller: We need a rate hike soon to pop ‘new-normal’ bubbles
By Barbara Kollmeyer
Published: June 1, 2015 10:46 a.m. ET
Pop that bubble before it gets too bad, says Robert Shiller.
There’s only one way to deal with the speculative bubbles that exist in the housing and asset markets: a Federal Reserve stick pin.
That’s the advice of Nobel Prize-winning economist Robert Shiller, who told CNBC on Monday that an early interest-rate hike is needed to stop the booms. “There are places in the United States that are really in bubble territory. For example, San Francisco [real estate] is hot, hot, hot. They’re going way over the asking price. Every house sells quickly,” he said.
The problem with central banks like the Fed is that they tend to “ignore speculative bubbles until it’s too late, and that may be the case now, said Shiller. “Stock markets in the U.S. are quite high, and prices in the real-estate market are getting high.”
In a recent CNN article entitled “House hunting horror stories,” several would-be first-time buyers relayed tales of woes. Those include a Denver couple who has all but given up after touring 30 houses and finding a nightmare of deceptive list prices and bidding wars. In Dallas, one hopeful spoke of California money pouring into Texas and driving up prices.
Shiller said rising stock and house prices are part of the “new normal” boom, which he described as a “funny boom in asset prices because it’s driven not by the usual exuberance, but by an anxiety” about jobs and the aftermath of the 2008 financial crisis.
Many analysts don’t expect the bull market in stocks, now in its seventh year to derail soon, but they also think gains will come far less easy. Indeed, the S&P 500 SPX, +0.09% is up just 2.4% so far this year. And there’s plenty of talk of too-expensive stocks.
The price-to-earnings ratio is at 17.5 on a 12-month trailing basis, according to FactSet, well above 10-year average of 15.8. The cyclically adjusted price-to-earnings ratio, or CAPE, has topped that 2007 peak, which means expected 10-year returns are in the low single digits, based on Shiller’s studies.
In an interview with Goldman Sachs strategist Allison Nathan that published over the weekend on Zero Hedge, Shiller said the bond market looks most likely to be in a bubble.
But with so many assets looking expensive, he said the best thing for investors to do is “save more because their portfolio probably won’t do as well as they imagined.”
So, I should be so concerned that some form of government bond ( which he also means emerging market bond) can’t make an interest payment or rather interest rates go up making existing bonds less attractive to pension funds, causing a rush to sell those bonds.
Well I’m not. Investing isn’t risk free. If pension funds think the government has their back this time around, fuck em.
“with new regulations punishing such trading (via higher capital charges), banks and other financial institutions have reduced their market-making activity. So, in times of surprise that move bond prices and yields, the banks are not present to act as stabilizers.”
This is the problem with the Elizabeth Warren approach – trying to regulate their way to perfection. Rather than increasing banks’ capital requirements, they should have forsworn any interventions, although that ship had already sailed when Hank Paulson backstopped Fannie/Freddie mortgage-backed securities in 2008 (and arguably as far back as Long Term Capital Management).
I remember watching the 2010 crash go straight down 999 points in 15 minutes. Wall street is musical chairs in a house of cards run by four-flusher mountebanks and the suckers won’t be able to buy a warm cup of pee.
There are as many stocks rising to highs as falling to lows
By Mark Hulbert
Published: June 2, 2015 5:00 a.m. ET
That divergence in the past has presaged a bear market a third of the time
CHAPEL HILL, N.C. (MarketWatch) — The odds of a big drop in U.S. equities are high and increasing.
One of many warning signs is the small number of stocks keeping this market afloat. Only 4.5% of stocks on the New York Stock Exchange rose to new 52-week highs last week. There were almost as many issues (4%) that fell to new 52-week lows. Still, the NYSE rose to a record of 18,351 just last month and closed at 18,040 on Monday.
It’s not healthy that those two percentages are so similar, according to Norman Fosback, the former head of the Institute for Econometric Research and currently editor of Fosback’s Fund Forecaster. “Under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows — but not both,” Fosback wrote in his investment textbook “Stock Market Logic.” “A healthy market requires some semblance of internal uniformity.”
The absence of such is also showing up in an increasing number of market divergences. Perhaps the most widely followed is the one between the Dow Industrials DJIA, +0.16% and the Dow Transports DJT, +1.14% : Over the past six months, as the Industrials were hitting a series of new all-time highs, the Transports were dropping. As a result, today we have the extraordinary situation in which the Industrials are within shouting distance of their 52-week high and the Transports are 10% below theirs.
To calculate how rare this gap is, I analyzed the historical data back to when these Dow averages were created in the late 1800s. I looked for all situations in which, like today, the Dow Industrials were within 1.5% of their 52-week high and the Dow Transports were at least 10% below. If there was more than instance of such a divergence within a 90-day period, I focused only on the first such instance.
Counted in this way, today’s divergence has happened 33 other times since the late 1890s, or once every three or four years. The last one occurred in September 2007, the month prior to the October 2007 bull-market top.
The good news is that not all of those 33 prior divergences led to a bear market. But the bad news is that many of them did: In fact, in 12 of the 33 cases, a major bear market decline of more than 20% began within six months. On average across those 12 cases, the bear market began 62 days after the first appearance of a divergence that was as pronounced as the one we’re experiencing today.
So one way of gauging the risk in today’s market is that, assuming the future is like the past, there’s more than a one-in-three chance that a major bear market will begin in the next two months.