A recent report from Citi Research titled The liquidity paradox spells out in some detail how the copious liquidity being supplied by central banks worldwide is not entirely innocuous economic stimulus. Citi analyst Matt King illustrates how excess liquidity is leading to homogenous markets and one-way trade, and is a major factor in volatility-related phenomena such as flash crashes.
King notes: “We argue that in addition to regulations, central banks’ distortion of markets has reduced the heterogeneity of the investor base, forcing them to be the “same way round” over the past four years to a greater extent than ever previously. This creates markets which trend strongly, but are then prone to sudden corrections. It also leaves investors more focused on central banks than ever before – and is liable to make it impossible for the central banks to make a smooth exit.”
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The problem with herding (or one-way-trade)
The Citi report starts off by noting that an ideal market would be one with “a small number of homogeneous securities being traded by a much larger number of heterogeneous participants.” As he points out, in this kind of market buyer and seller are both motivated to make a transaction, and are thus more likely to easily agree upon a price.
However, in markets today, not only has the number of securities traded continue to grow (especially in credit markets), but the heterogeneity of market participants seems to be shrinking.
Various regulations have certainly had an impact on this situation, with more and more investors now having to mark to market and to hold capital or cover pension gaps. King also highlights: “it feels to us as though market participants are increasingly looking at the same factors when they make their investment decisions.”
Is “herding” caused by over liquidity leading to flash crashes?
In fleshing out his argument that excess liquidity is leading to one-way-trade and rapid market swings, King argues that valuations in an increasing number of markets seem to have stopped following traditional relationships and are tracking global QE instead.
He says: “Record-high proportions of investors think fixed income is expensive and think equities are expensive. A growing number of property market participants seem to think real estate is expensive. And yet almost all have had to remain long, as each of these markets has rallied. Could it be that central bank liquidity has forced investors to be the same way round more so than previously, and that this is making markets prone to sudden corrections?”
King also notes other data also point to ongoing “investor crowding”. Citi’s credit survey shows that investors’ positions in credit since the crisis have not only been longer on average than ever in the past, but also less prone to revert to the mean, and also showing less dispersion. A solid 83% of those surveyed were long credit in December last year, which is a huge imbalance for any market at any time. Also of note, the BAML global investor survey highlights that today’s investors have been long stocks for much longer than the historical norm.
Moreover, an IMF analysis of the correlation between individual securities transactions by American mutual funds, shows an obvious increase in investor crowding with the crisis, and then again in late 2011. The herding was evident across markets, but was especially notable in credit (particularly EM) more than in equities. also occurred both with retail and institutional investors.
Finally, the Citi report highlights that most investors are savvy to the import of the actions of central banks. In a recent survey of global credit derivatives investors, more than 65% thought “central bank actions” would be the primary influence on spreads this year, more than “credit fundamentals”, “global growth trends” or “geopolitical risks”. Moreover, as King points out, “even if the central banks are only having to intervene because the systemic risks they are confronting have become bigger, the effect remains the same.”