Don’t confuse illiquidity and volatility – Pimco

Financial markets have undergone substantial changes as a result of regulatory shifts, but according to Pimco’s global head of portfolio risk management, William de Leon, much of the volatility currently in evidence has more to do with central-bank induced uncertainty than illiquidity.

Don’t confuse illiquidity and volatility – Pimco

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Acknowledging that financial markets have gone through seismic changes since the global financial crisis as a result of the passage of regulation geared toward improved financial stability and reduced systemic risk, which has not only led to bank consolidation, lower leverage ratios and less use of derivatives and related financing, but also to pockets of diminished market liquidity, de Leon does not believe conditions are as substantially different as some perceive them to be.

“We think the period of lower volatility when interest rates were near zero and the Federal Reserve seemed to be on hold ‘forever’ has given way to a period of higher volatility due to more uncertain central bank policy,” de Leon argued in a new note.

Adding that abrupt changes in valuations are not necessarily liquidity events, de Leon says they could just as easily be caused by a surprisingly weak non-farm payrolls number – a scenario he does not expect – but one that would see equities re-price sharply lower and prompt investors to change their asset allocations.

Two real life examples of such events, de Leon said, include the stock market crash of 1987 when equities dropped over 20% and the Swiss National Bank’s sudden decision last year to remove the franc’s peg against the euro, leading to a 20% move in one day.

“While these market movements were violent and bid/ask spreads widened, they were asset re-pricings ‒ not liquidity events. The market adjusted shortly after these events, liquidity returned and volatility fell.

“These examples belie today’s “illiquidity illusion” ‒ this is not a dysfunctional market. Increasing bid/ask spreads, higher volatility and changes in asset preferences indicate a state of change in market conditions, but not necessarily a lack of liquidity,” he added, pointing out that investors should be clear to differentiate between volatility and illiquidity, and policymakers should be careful not to misdiagnose the problem they are trying to solve.

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