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Citigroup: Something Big and Fundamental Has Changed in Markets

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Liquidity in bond markets has grabbed all the headlines in recent months (and years).

The ability to trade fixed-income securities without overly affecting prices is front and center in the minds of many investors, traders, and regulators, although there’s plenty of disagreement as to the extent of the so-called liquidity issue, as well as the reasons behind it.

New regulations that have made it more difficult or more expensive for banks to hold bonds on their balance sheets and to facilitate trades for their clients are an oft-cited culprit, though the growth of the big investors that buy such assets is an additional factor.

In a new presentation, Citigroup Strategist Matt King argues that the liquidity issue is a pervasive one that expands beyond fixed income and cannot be solely attributed to shrinking bank balance sheets.

In the 42-page presentation, King points to increasing concentration and one-way positioning by large investors as a major factor behind current liquidity woes.

The crux of this argument is that markets used to be self-limiting. Prices of securities would move up to a point where their yields would become unattractive, at which time investors would trim some of their positions, causing prices to go down and yields to recover. Now the intense search for returns has altered that dynamic, with investors chasing inflows as a means of getting higher prices and higher profits.

While the notion that  value investing is disappearing in a market that has moved ever upward for the past five years is not exactly new, King’s presentation here is stark. Investors have been moving in tandem, he says, making markets far more homogenous. The chart below shows investor positioning in credit markets, where the number of longs has vastly outnumbered the shorts, along with the International Monetary Fund’s herding metric. In short, investors across a number of asset classes are going mooo as one-way positioning dominates.

Should investors decide to change positions all at once, liquidity will, understandably, evaporate.

The good news here is that some of that herding behavior may fade as the U.S. raises interest rates, global economies begin to diverge, and cracks emerge within asset classes. The bad news is that we’re vulnerable to hitting market air pockets, so to speak, until then. 

Here is King’s conclusion: Buckle up.


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