ebook essays pieces of the puzzle
Monday, April 8th, 2013
liquidity watch

13 0408 liquidity watch

I last posted a version of this chart in early September 2011, when the lines in each of the four panels were in the midst of noticeable drops.  Two weeks later, the Fed began “Operation Twist,” one of its many maneuvers over the last few years.

Since then (from top to bottom):  The Citigroup Liquidity Index has been in neutral other than a brief tumble in the second quarter of 2012 (the line moving lower equals less liquidity); the ten-year note had a big drop last week, although it’s lost given the scale of the rate decline since 1997; the S&P 500 has been resilient; and measures of volatility have not blown out to any degree during the last eighteen months.

In the fateful month of October, 2008, I wrote that, like love, liquidity has “a nasty habit of disappearing overnight.”  I’m not predicting that now (of course, I’m not in the prediction business), but it seems like a good time to think about the availability of liquidity and the effect on strategies of it being taken away.

Are there crowded trades out there?  Probably.  Is it painful to be on the wrong side of one?  Always.  But quick and sizable moves from the unwinding of those trades don’t necessarily require a lack of liquidity.  (The shorts in the ten-year got hammered of late, but I wouldn’t say a lack of liquidity was the reason.)

However, there are reasons to be on liquidity watch.  Many in the fixed income markets are concerned about the decline in liquidity in some sectors; for example, holdings in corporate bonds by primary dealers are lower than they were ten years ago and it’s unlikely you’re going to get much of a bid if things get dicey.

Also, there is great debate over the true liquidity in the stock market, given the propensity of high-frequency trading strategies to step out at times of stress and the increase in “dark” trading.  Moving size is a different process entirely from what it used to be.

At the margin, what does that mean?  I don’t know, but I have a sense that those considering the question will be better prepared for the next drop in all of those lines on the chart.  (Chart:  Bloomberg terminal.)

wicked environments

Regular readers and clients know that I love to triangulate — to come at ideas from a variety of angles.  My latest posting, on wicked environments and investment expertise, does just that based upon writings by Bill Gross, Daniel Kahneman, and Gary Klein.