Event risk creating global upheaval
A series of macro events have caught portfolio managers by surprise and prompted investors to act. The war in Ukraine and China’s COVID-zero policy have exacerbated inflation by putting a fire under commodity markets and disrupting supply chains. Global markets remain skittish even in response to anticipated events, with large swings following regular central bank meetings and official data releases. The volatility is keeping investors on the sidelines and creating a challenge for traders when pricing products. “There is always an event around the corner and a reason for investors to sit close to benchmark or sit defensive and that just exacerbates the problem,” said Greg Kumar, Head of Australian Dollar Rates Trading at RBC Capital Markets and a panelist at the recent Kanga News Sustainable Debt Summit.
"I had a conversation with a very senior investment grade credit trader in the US and his commentary was that liquidity is as bad as he's seen in his 15 years.”
Electronic trading is adding to liquidity trials
The shift toward electronic trading, through algorithmic and other high-frequency programs, has contributed to the liquidity challenge as machines re-price markets much faster than humans. Over 60 per cent of US equity market trades are now guided by algorithmic trading.1 Electronic programs are often supplying much of the depth in markets, leaving investors exposed when shifts occur.
"What tends to happen in times of heightened market stress is the exit button gets hit and suddenly the depth and the liquidity within the market disappears,” said Kumar.
“The size and scope of these moves is something I haven't seen in my career.”
Traders are taking smaller positions
With balance sheets tightened due to regulations introduced in the wake of the 2008 global financial crisis, banks now hold fewer assets, limiting traders’ ability to execute large positions for their clients. This has led to more turbulent trading and a more conservative approach to risk. With prices often highly sensitive to large deals, traders are taking smaller positions or keeping positions open for longer to find buyers.
The volatility has led some traders to return to conventional broking and a more hands-on relationship management approach with their clients.
"We're sensitive to the needs of certain clients that need instantaneous liquidity," Kumar said. "That is where the trust and relationships come into it. I think for those clients in a distressed time there is an understanding that there will be a certain price to pay for that liquidity.”
Offshore investors deterred from Australian market
Australia has not been immune to the liquidity crunch, with offshore investors having exited the market in search of value elsewhere. The break-down in the Reserve Bank of Australia’s experimental yield curve control policy proved a difficult trade for some investors, said Kumar.
“We’re just missing the other side of our flows. So that is really exacerbating liquidity, not just in the front end but also longer out the curve,” he added.
Investors can find more value in the front end of the sterling curve or in North American markets.
Until investors see credit spreads re-price or a dramatic change in the rates dynamic, the off-shore cohort of investors are unlikely to come back to the Australian market in any material size.
“There’s no natural need to be invested in the Aussie market right now,” said Kumar.
Investors are finding value in Japan
Japanese investors, in particular, have exited Australian positions in high volumes this year and may see little incentive to return in the short-term.
Annuity funds issued by Japanese insurers for retail investors have been exiting Australian dollar assets as the yen slides in value while the Bank of Japan maintains a program of quantitative easing. Sales have been driven by automatic triggers set up by the annuity funds and linked to the Australian dollar’s appreciation relative to the yen.
“A lot of it was invested in credit, so at a time when the market was less able to cope with that, it had a lot of bonds swamping the market,” said Kumar.
With other major central banks undertaking quantitative tightening and shrinking their balance sheets, Japan is now offering attractive conditions for home investors.
“What has really changed for the Japanese investor base is for the first time in many, many years, they now have a domestic market that offers quite attractive value," Kumar said. "They've got a curve that offers the investor base value in longer dated yields … It becomes more palatable for that investor cohort to keep their funds domestically.”
With rising yields and widening spreads, Australia may now be presenting more opportunities for investors but traders have yet to see flows return.
With volatility keeping investors on the sidelines, finding liquidity may continue to be a challenge for traders in coming months.
“It’s just going to take time,” said Kumar.
“As the price action settles down, as investors look back at their RV (relative value) and do their analysis, (Australian fixed income) is a compelling, safe and high-yielding asset class.”
1. Refinitiv, July 2020, Finding market liquidity insights with data science
