Global markets are suffering some of the worst turbulence since the euro zone crisis. Economic problems explain part of the melee. But a shortage of liquidity – the trading sort, not the kind that central banks inject – have amplified price swings.
The signs of disarray are everywhere. On Thursday, Europe’s gauge of stock market volatility hit its highest since 2012. Stocks slumped and yields on peripheral euro zone bonds rose. Greek 10-year debt was set for its worst two-day selloff since 2012. The gainers were the safest government bonds, with German 10-year yields hitting a record low of 0.72 percent.
The list of economic worries is long, from weakening euro zone economic activity to the effect of Ebola. But there’s nothing new or dramatic enough to explain the violence of the price moves. Technical factors are playing a major role, and far too many sellers are trying to unload assets on far too few buyers.
On the selling side are investors who tried too hard to escape the low yields that were the result of accommodative monetary policy and low inflation. They bought riskier, higher-yielding assets “on the presumption of a level of liquidity which was not there,” as Guy Debelle, an Australian central banker, said on Oct. 14.
On the buying side, there is a dearth of counterparties. Regulation has sharply circumscribed proprietary trading at banks and made them less willing to hold huge inventories of assets. When prices are falling, today’s market-makers are only willing to buy at vastly reduced prices. As prices gap downward, more investors decide to sell, or are forced to by margin calls.
But a small change in sentiment or the crossing of some line on a chart can cause a dramatic reversal. The brakes are not working well in either direction, so the crowd rushes through narrow exits or into narrow entries. The process tends to be self-reinforcing, especially when so many investors put their trust in trading algorithms which can force sales in falling markets.
At some point, everything will be cheap. But value will be hard to spot until sellers and buyers are more evenly matched.