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CITI: Central banks' plan to create mass liquidity in markets may now be having the opposite effect

Farmers hoping for rain in NSW. Photo: Getty Images

The flash crash of 2010 and taper tantrum of 2013 were examples of sudden vacuums where market liquidity disappeared and prices moved counter to their trend.

It’s a recipe for massive market dislocations, huge losses by traders and investors and, the risk of such events appears to be increasing, not receding, despite seven years of central bank liquidity provision.

That’s the view of Citibank analyst Matt King in a research report released last week titled, The Liquidity Paradox – The more liquidity central banks add the less there is in markets.

At the heart of King’s argument is that just like the many occasions over the years when USDJPY was used by forex traders as the funding currency for “carry trades”, investors over the past few years have increasingly “crowded” into one side of the global bond and stock market rally. King said:

The investor base across markets has developed a greater tendency to crowd into the same trades, to be the same way round at the same time. This “herding” effect leads to markets which trend strongly, often with low day-to-day volatility, but are prone to air pockets, and ultimately to abrupt corrections.

Liquidity – the ability to move in and out of positions smoothly because of a high level of buyers and sellers in a market – seems abundant as central banks provide cash and support markets. King notes that over the past four years “it is expectations of central bank liquidity, not economic or corporate fundamentals, which have become the main driver of everything from €/$ to credit spreads to BTP yields.”

That means that even though investors and traders are all one the same side of the trade the “air pockets” that markets have experienced over recent years are just a curiosity at the moment, King says, mainly because they have been resolved so quickly “having had little or no obvious feedthrough to longer-term market dynamics, never mind to the real economy.”

But these events are unlikely to remain simple curiosities, given markets have to deal with an FOMC which has made it clear that it is more than likely going to raise rates in 2015. That’s especially so given that the US labour market has an unemployment rate of 5.4%, a level that seems more compatible with 3% or 4% cash rates rather than the current level of zero. It’s also the case given that the Bank of England, after David Cameron’s victory and likely improvement in business and consumer confidence, won’t be far behind the FOMC.

The problem at the moment is that, as King says, “Markets are liquid when they work both ways.”

But markets are all heading in the one direction because central banks are creating artificial liquidity on the way into these globally uni-directional trades where “market participants… find themselves increasingly needing to move the same way.”

That’s a risk when the chair of the Fed, Janet Yellen, warns that both bonds and stocks are overvalued.

King said that means when the central banks step back, as they inevitably will, “the way out may not prove so easy; indeed, we are not sure there is any way out at all.”

That’s a worrying prediction.

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