Monday, May 11, 2015

El-Erian On Market Liquidity

From Business Insider:

EL-ERIAN: This is 'one of the most under-appreciated risk factors facing most investors today'
With more people expressing concerns about market liquidity, we reached out to Mohamed A. El-Erian to get his take. Here’s our Q&A with him.

How worried are you about market liquidity?
I think of this as one of the most under-appreciated risk factors facing most investors today.

What do you mean specifically?
Aided and abetted by ultra-loose central bank policies, investors have collectively embraced a liquidity illusion — or, to be more precise, stumbled into a liquidity delusion. As a group, they believe that, should conditions cause them to change their collective mind, there will be enough liquidity in markets to reposition their portfolios with relative ease and at a relatively low cost. But this belief runs counter to both structural conditions on the ground and recent market signals.

Over the last few years, there has been a pronounced decline in the risk absorption appetite of broker-dealers. Their intermediation capabilities have shrunk not just in absolute terms but also relative to the enormous growth in the end-user investor base.

Tighter regulations and less patient shareholders have restricted the ability of broker-dealers to deploy their balance sheets counter-cyclically. As such, they have limited appetite when it comes to accumulating inventory in the event that a large chunk of the investor base decides to go the other way.
The result has been a series of sudden out-sized price moves in quite a range of markets, from sovereign bonds to foreign exchange, emerging markets, and high-yield corporates. Fortunately, due to the stance of central banks, most of these episodes have proven -- at least so far -- to be short in duration, temporary and reversible.

What are the implications?
Think of the following possible sequence as an illustration of the underlying dynamics of this risk factor:
  • First, a sudden change in the investment paradigm -- such as that that triggered the May-June 2013 Taper Tantrum or this January’s Swiss National Bank decision to alter its currency policy -- creates widespread investor demand for portfolio adjustments.
  • Second, broker-dealers either attempt to step back from the marketplace altogether or only agree to transact at very wide bid-offer spreads and only in small size.