All in all, going forward we think that it is rational to expect further episodes of liquidity-induced volatility and believe that a fundamental based approach can go a long way in mitigating this important risk dimension, which is now likely to be permanently connected with global fixed income investing.
Macro versus micro liquidity
On the monetary policy front, we have had both the sharp expansion of central bank balance sheets witnessed in the aftermath of the Great Financial Crisis of 2008/9 and metamorphism of large scale asset purchases as mainstream monetary policy tools. As a direct result we have seen an explosion of what we call “Macro” focused liquidity (intended to stimulate growth and inflation). However, at the same time a raft of new regulations in recent years designed to make the financial sector “less risky” have had the direct effect of damaging the intermediation capabilities of the banking sector. Indeed, this well understood mechanism can be seen as regulation driving a direct increase in the cost of balance sheets leading to a much reduced appetite for risk. The consequence is a reduced ability of banks to act as a warehouse between buyers and sellers (see chart 5 which plots the size of credit markets against dealer inventories).
Role of QE in fracturing micro liquidity
A critical unintended consequence of creating macro liquidity via the introduction of a price-insensitive buyer (i.e., the printing press) has been the forced convergence of market views around expected risk asset premia. This has been powerful over the last few years and is clearly demonstrated in increased herding amongst investors and the accompanying steep fall in bond market turnover (reflected in metrics complied by institutions such as the IMF and Citibank in charts 1 to 3).
For investors, increased herding and regulation-driven reduction in dealer inventories represents a major challenge; conventional metrics such as bid-offer and traded volume are failing to capture the non-linearity now present in the system, with the market seeing higher incidence of air-pocket creation leading to episodes of very sharp (and often low-volume) driven out-sized price-moves.
Central bank policy credibility
We firmly believe that assessment of the damaged micro liquidity environment is now an important third dimension relevant for fixed income investing (in addition to expected risk and return). However, we think that the long-term outlook for fixed income risk premia is more likely to be shaped by market views around policy credibility of key central banks rather than micro liquidity issues in isolation. As an example, as we have seen in recent high volatility episodes (October 2014 and April/May 2015) these so far have tended to be short-lived. Given the resulting shift in underlying financial conditions, the market moves have in turn attracted indirect/direct policy interventions (e.g. ECB announcing the front-loading of its QE programme recently after the sharp sell-off in bunds).
Looking ahead, the ongoing journey towards the start of the hiking cycle in the US is key and is likely to be impacted by the market reaction (especially if we see signs of overreaction as we did in 2013). This in turn is very likely to be strongly shaped by the underlying micro liquidity situation. On the ECB front, we are less concerned about the outlook around the main thrust of their QE policy than by the risk of political noise if it starts being viewed as ineffective by influential member banks (mainly the Bundesbank), again at a time when the underlying liquidity picture is to damaged. However, both these risk factors remain, in our view, tail scenarios, given ongoing subdued inflation and the continued downward pressure on global growth projections.
Fixed income investing in a world of fractured micro liquidity
As discussed above, with this backdrop of significantly increased regulation and QE, micro liquidity accidents are occurring more frequently and thus far they have remained as concentrated events of sharp market moves over short periods of time. Given this reality of a permanently distorted micro liquidity environment, we think that access to fixed income risk premia can be improved significantly by adopting a fundamental based approach to underlying allocation to specific issuers (both corporates and sovereign). Chart 4 illustrates the three dimensional choices we think fixed income investors face when deciding to access bond market risk premia.
Here, we think investors with the need to hold fixed income risk premia should consider a buy and maintain approach, taking into account the fractured micro liquidity situation and the continued usage of fixed income risk premia by central banks as monetary policy tools and the unintended implications. Indeed, with this approach underlying credit impairment risk becomes key which we think can be mitigated by a fundamental view of issues/ issuers rather than a market-cap approach. Specifically, unlike market-cap benchmarks which directly causes herding into the most leveraged issuers, the fundamental approach mitigates herding by focusing on quality based diversification. In our view, during fractured liquidity driven volatility episodes, this can be a very valuable portfolio attribute. It is also important to remember that from a credit impairment perspective, the herding induced by market-cap benchmarks can be counter-productive as it forces investors to lend to those companies/sovereigns that tend to be the most leveraged.
All in all, in a world of damaged micro liquidity (which is unlikely to improve anytime soon), we believe the benefits of using a fundamental focused approach to fixed income have increased significantly.
Herding among US mutual funds is on the rise (average measure of herding by type, mean, %)
Retail funds tend to herd more but upward trend visible in both categories
Government bond market annual turnover (times)
Three dimensional choice set facing fixed income investors
Dealer inventories have shrunk to a quarter as corporate bond holdings have doubled
Salman Ahmed, Global Strategist, Lombard Odier Asset Management
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