Chaos has reigned supreme in global markets recently.
There was a period in late August when over the course of a week there was a so-called seven-sigma move in equities, an all-time record change in the volatility of volatility, a 700-point change in the S&P 5oo over a week, and four consecutive days of six-sigma moves in oil.
In short, stocks and commodities were seeing nearly unprecedented price swings on an almost daily basis.
And these moves followed huge swings in bond and currency markets over the last couple years: US Treasuries, German bunds, Japanese government bonds, and the Swiss franc have also experienced flash crash-like wild swings, highlighting increased volatility across asset classes.
Douglas Peebles, head of fixed income at Alliance Bernstein, and his colleague Ashish Shah, head of global credit, set out a series of reasons for the increased volatility in a note titled ‘Playing with Fire.’
The note primarily focuses on reduced liquidity in the fixed income market, but also helps explain why there has been such huge volatility in the price of almost anything an investor can own.
“Anyone who buys and sells bonds for a living has noticed that it’s harder than it used to be,” the report said.
Peebles and Shah cite stricter banking regulations for reducing the amount of inventory held by banks, making it much harder to trade large bond positions without moving prices. This means it only requires a small amount of buying or selling to send prices heading downwards.
The report added: “While banks have been retreating from the bond market, investors have been charging into it. This is a direct result of central banks’ easy money policies: by driving interest rates to record lows, these policies pushed investors — even income-starved mum-and-pop investors — into riskier assets, such as high-yield bonds and emerging-market debt, to earn a decent return.”
Mutual and exchange-traded funds that are oriented towards retail investors owned nearly 23% of the US high yield market in 2014, according to the note, up from 15% in 2006.
Retail investors are generally regarded as being more easily spooked than large institutional funds, and the increased ownership of riskier asset classes like high yield bonds by mum-and-pop investors increases the likelihood that there will be heavy bouts of selling at times of uncertainty.
It used to be the case that institutional investors would step in and pick up bargains when they sensed that the market may be oversold. But here too, there has been a change following the financial crisis.
Alliance Bernstein adds: “Determined to avoid a repeat of the big losses the crisis inflicted, many large investors, including insurance companies, risk parity funds and even high-net-worth individuals, have adopted new risk-management strategies that have the potential to make liquidity conditions worse. This is because the investors who use these strategies may act the same way at the same time.”
The risk management strategies often rely on measuring and reacting to value at risk, which measures the level of risk within an investment portfolio and is sensitive to volatility. When volatility falls, these funds buy. When it spikes, they sell.
A number of market participants have said volatility-induced selling led by risk parity funds, which target exposure to volatility rather than say equities or bonds, exacerbated the sharp sell-offs of October.
Then there is correlation between asset classes.
When the Federal Reserve first hinted it would reduce its monthly asset purchases in 2013, markets went into a spin, with this period now known as ‘the taper tantrum.’ The episode was widely regarded as evidence of how dependent the market was on central bank buying, but also highlighted another issue, according to Peebles and Shah.
“That episode (and a few others since then) was also notable for another reason: the prices of bonds, stocks, commodities and other assets all declined. Normally, riskier assets such as equities, commodities and high-yield debt are negatively correlated with Treasuries and other safe assets. When risky assets fall in value, safe ones rise. But correlated sell-offs — one might call them miniature fire sales — are becoming more common.”
These miniature fire sales are particularly challenging for risk-parity funds, which typically assume correlations are stable and negative.
When the correlations turn positive – that is to say assets move in lock-step – the funds sell both equities and bonds to maintain their risk targets.
So more forced selling.
Then there is the foreign exchange market.
Record-low interest rates have forced investors overseas in search of returns. Japanese investors poured about $US86 billion into foreign fixed-income markets in 2014 alone according to the note, citing Japan’s Ministry of Finance.
That comes at a time when currency markets have become less predictable, as central banks around the world implement diverging monetary policies. The US Federal Reserve could be about to raise rates, just as Europe embarks on further monetary easing. China is trying to manage a devaluation of the yuan. The Swiss franc surged nearly 20% against the US dollar in a single day earlier this year.
The note said: “With so much money chasing returns overseas, sharp currency moves like this one could suddenly turn large numbers of credit investors into forced buyers or sellers.”
The note concludes that these factors force investors to behave in the same way at the same time.
“That distorts asset prices — investors end up buying when things are expensive and selling when they’re cheap — and it suggests investors are less likely to find that their asset is liquid when they need liquidity most. If something were to trigger a sharp market decline, there would likely be plenty of sellers, but precious few buyers.”
It adds that many investors may not have a choice but to sell, whether that be because of volatility, sharp exchange rate moves or margin calls. And banks won’t be around to soften the fall.
“In other words, if a fire starts, each of these trends may act as an accelerant.”
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