As commentators focus on this early morning’s price action, including some notable gapping dynamics, investors are well advised to keep an eye on underlying market liquidity. The “sucking sounds” of prior days are getting louder as four factors come together. And while not a “Lehman Moment,” investors should be careful as such nasty market technicals can feed onto themselves.
Dislocated liquidity conditions — as in wider and more volatile bid-offer spreads, considerably less intermediation appetite among dealers, etc. — are cascading down from the most levered market segments. The direct and immediate causes are:
- Greater market volatility forcing more formulaic and VAR-based accounts to reduce positions in an accelerated fashion
- Crossover investors trying to get back to their “home asset classes,” and finding it hard to do so in an orderly fashion
- An outflow of funds from mutual funds and other accounts; and, of course,
- Reduced willingness among dealers to make markets and, in the process, resisting to hold much inventory
In essence, the liquidity underpinnings of markets can no longer support the overall positioning of investors overly comforted by the prolonged and repeated interventions of hyper active central banks using experimental policies.
Determining whether this is just a temporary blip or what economists call a “multiple equilibrium” (i.e., rather than mean revert, an unpleasant outcome increases the probability of a subsequent worse outcome) is essentially a call on two main issues: the health of the underlying fundamentals relative to market pricing, and the availability of balance sheets to step in with stabilizing liquidity.
Given current indicators, this periodic phase of dislocation in market liquidity — and they do occur occasionally — is likely to continue in the immediate period ahead.
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