Declining liquidity and a surge in the number of hedge fund redemptions have eerie similarities to events prior to the financial crisis and could be “harbingers” of further market turmoil to come in 2019.
Writing on December 28, a Deutsche Bank team led by the analyst Masao Muraki said that liquidity had started to dry up in certain areas of the market and that it was a concern for the already battered global stocks. Lower liquidity generally means bigger swings in market prices because fewer trades generate a bigger impact on the market.
As liquidity has declined, Deutsche Bank’s analysts wrote, so has the number of hedge fund redemptions increased, something that not only could be a “harbinger” for further market volatility but that also has echoes from the months before the financial crisis.
“News of hedge fund redemptions has emerged since October 2018,” Muraki and his team wrote. “The sustained high level of volatility has worsened the profitability of consensus trades based on market momentum, and the fall-off in market liquidity has generally hurt their performance as well.”
If the markets continue their negative trajectory, and early signs in 2019 are that they are likely to do so, then falling liquidity could help make downward moves even larger.
“We recall that the unwinding of quant funds in August 2007 and macro funds in October 2015 were harbingers of subsequent market turbulence,” they continued.
Many view evaporating liquidity in parts of the market in late 2007 as one of the first concrete signs the financial crisis was beginning to crystallize.
In August 2007, France’s largest bank, BNP Paribas, froze withdrawals from three investment funds, citing “the complete evaporation of liquidity in certain market segments,” which it said “made it impossible to value certain assets fairly regardless of their quality or credit rating.”
The event was cited by Alistair Darling, the UK’s chancellor of the exchequer at the time, as the moment he knew that a major crisis was on its way.
Deutsche Bank is not the first institution to warn about falling liquidity. Back in July, Rick Rieder, the chief investment officer of global fixed income at the asset-management giant BlackRock, said tightening policy from global central banks was straining bond market liquidity and starting to send shockwaves through markets.
Muraki and his team’s report ends on a somewhat reassuring note: Things are not yet at precrisis levels.
“We believe the level of maturity and liquidity transformation in advanced economies is lower than before the global financial crisis,” they concluded.