There was one thing keeping fund managers in the US up late on Halloween and it wasn’t the ghosts: it was the Fed, which is contributing to much tougher trading conditions for both pro and retail traders.
As earning season gets underway, trading desks are facing what are being described as once in a generation headwinds as economic conditions tighten. Traders are not only having to contend with heightened risk but also difficult markets that are not behaving as they have done in the past.
The VIX index for example, a traditional measure of volatility, is sitting at high levels, but not triggering the type of historical reaction to 3%+ moves in the major equity indexes. The market has become accustomed to the real price volatility, almost desensitized to it. And the wild moves are making trading conditions that much more difficult.
“Quant funds and traditional electronic market makers, or high frequency, have enjoyed the quickly shifting conditions this year,” said Jeff O’Connor, head of American market structure at Liquidnet. “Much of the volume has relocated to these sources, exacerbating the lack of real institutional flow – making individual stock trading that much more difficult.”
With realised correlations at extreme levels, coupled with the difficult trading conditions, traditional money managers are sitting on historic levels of cash. ETFs – exchange traded funds – which are becoming more dominant in terms of market liquidity all the time, are pushing to as much as 40% of total equity flows at times. This speaks to that avenue as an easier way to make a macro call in a single stock.
What’s happening to market liquidity?
Liquidity is falling, in particular, executable institutional volume, and with that the cost to trade increases significantly. Hence the recurring cycle of elevated cash positioning. This could also have knock on effects on the ability of brokers, including CFD brokers, to accurately price assets for individual traders. Trades that previously did not move the market are not shifting prices quite considerably.
“The macro backdrop will have to change significantly for traditional money managers to move out of their shelters,” Liquidnet’s O’Connor says. “But with this much cash on the side lines, when inflation and interest rate peaks start to signal a peak, the move back into markets could be explosive.”
This is certainly something we in The Armchair Trader are also noticing. There are literally dozens of highly undervalued companies out there. At the moment it is a short trader’s paradise, with many money managers telling us off the record that they and all their clients are currently in cash including short term deposits. They are keeping tabs on the market, but in the meantime are sitting on the side lines.
The Federal Reserve is also contributing to a lack of market liquidity, which will lead to a much higher level of volatility in both stock and bond markets. We are already seeing some very big swings in US Treasury yields. Companies like Main Street Research have flagged up levels of liquidity – or lack thereof – in the US Treasury markets not seen since 2008. There are some real concerns that this could feed into a further bear market in stocks.
Other key factors to bear in mind:
- Big buyers of US Treasuries are selling dollars to prop up their own currencies
- Big institutions which used to prop up the US bond market now need to maintain higher cash levels for their own balance sheets
- The US government may be forced to take action by purchasing older debt securities off the market
- Low quality bond markets – e.g. high yield – could get crucified first
- And finally, yes, this could affect emerging markets valuations too as risk capital dumps those stocks
