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I started work on Canada’s biggest dealer’s institutional equity desk in the early 1990s. I was hired to help another trader whose large index client was increasingly taking more of his time. Back then Wells Fargo was the world’s biggest index fund and serving them took a fair amount of technical skill to execute the large baskets they wanted to transact. As my boss later told me, “there were candidates that had better computer abilities than you, and there were candidates that had more trading experience, but no one had your mixture of both skills.” I was lucky to be at the forefront of the computerized trading revolution, and therefore I progressed quicker than many other traders. Within a couple of years I had graduated from serving index clients to running a large equity index derivative book. Most of our trading was index arbitrage and making markets in ETFs for institutional clients, but we quickly became the biggest index player in Canada.

Although I was good at laying off risk through various markets, I was still a young punk that hadn’t been around the block. I took for granted the seemingly bountiful amount of bids and offers in all the instruments I traded.

As I became more confident in my abilities, I made markets in larger and larger chunks of stock index ETFs for institutional clients. The other liability traders on my desk would struggle when forced to buy a big piece of a single stock – although they could hedge some of the risk out with positions in other similar type names, there was still a ton of single stock risk. But for me it was easy to bid or offer a million of an ETF on the quote. Our group’s ability to lay off risk was much easier. We would wander into the stock index futures pit and wind down our position. When we ran out of locals to stuff, we would work out the balance through program trading. For some kid in his mid twenties, it seemed like an easy game.

But I still remember the first day I realized that liquidity is not always there when you need it. I didn’t learn this lesson on some big down day when the market went no bid at any price (that lesson was still to come). No, my first realization you can be bigger than the market came on some innocuous summer afternoon. There wasn’t much going on and many traders had split to golf (back in the mid 90s everyone golfed and my lack of this skill made me an unusual oddball on the trading desk). One of our agency traders got a call asking us to bid on a few million XIUs (which is the Canadian equivalent of the SPY). I think I bid down a nickel and he pasted me. We got to work trying to lay off the risk. My partner in the futures pit started making sales. I got on the offers with sell programs in the box. We moved down all the quotes and managed to sell a quarter of the position at a profit. The next quarter was sold at breakeven, and then it slipped below our cost. We kept selling, but the bids were quickly disappearing. Usually when you move quotes, the new price levels encourage more liquidity. Traders think they are getting a deal, and are eager to take advantage of the immediate demand for liquidity. Yet when we moved the quote down, this time there was nothing underneath.

As we continued selling, other traders started thinking something was up, and they began selling alongside us. Next thing we knew, the market hit an air pocket. We were still long more than a million XIUs and the market was suddenly in a little mini-free fall.

We knew that it was our selling that had caused this mini-crash so I did what every brash twenty five year does – we started buying. Yup, next thing we knew we were getting even more long desperately trying to stop the rout we started.

Eventually we decided this decline in Canadian stocks was just stupid, and we phoned up our contact in the Chicago pits to hedge out our position by selling a few hundred S&P futures. We waited it out overnight, putting on an imperfect hedge, unwinding our large long the next day when liquidity had returned to the Canadian stock market. I think we managed to only lose a little, but it was scary to realize how quickly the bids could disappear.

I was young and stupid. I didn’t yet understand that liquidity isn’t always there when you need it. No one had taught me the famous line about liquidity being too plentiful when you don’t need it and the moment you do need, it runs and hides. In the coming years as we were hit by the Russian default and then the Long Term Credit Crisis, I would come to learn the full extent of liquidity’s cowardice…


We could hit an air pocket at any moment

I think there are so many trades out there today where we could hit an air pocket at any moment. Whether it is the crowded US dollar long trade, or the stock market that is hitting new highs mainly on Central Bank buying and company buybacks, or even the stupid mad rush into German bunds at 0.06% yield – any of these trades could reverse in a heart beat.

The scary part is that more and more of these trades are divorced from fundamental values. Interest rates have been squeezed down to zero (and below) by overzealous Central Bankers. This has underpinned a dramatic rush into all sorts of different risk assets and other higher yielding instruments. In some cases, Central Banks are not only facilitating risk asset appreciation through easy monetary policy, but they are actually monetizing their balance sheet directly through equity purchases.

At some point there will be a change in sentiment, and when that comes, there will be precious few bids below.

Recently some prominent financial leaders have been warning about the problem of declining liquidity. JP Morgan CEO Jamie Dimon wrote about this worry in his latest company letter:

Recent activity in the Treasury markets and the currency markets is a warning shot across the bow.

Treasury markets were quite turbulent in the spring and summer of 2013, when the Fed hinted that it soon would slow its asset purchases. Then on one day, October 15, 2014, Treasury securities moved 40 basis points, statistically 7 to 8 standard deviations – an unprecedented move – an event that is supposed to happen only once in every 3 billion years or so (the Treasury market has only been around for 200 years or so – of course, this should make you question statistics to begin with). Some currencies recently have had similar large moves. Importantly, Treasuries and major country currencies are considered the most standardized and liquid financial instruments in the world.

And it’s not just sell side CEOs trying to scare Congress into loosening the Volcker rule on proprietary trading. Even buy side guys are worried:

Prudential Investment Management Chief Executive Officer David Hunt says the No. 1 concern among bond buyers globally is liquidity and its rapid disappearance.

“The biggest worry of the buy side around the world is that there has been a dramatic decline in liquidity from the sell side for many fixed income products,” said Hunt, 53, who heads Prudential Financial Inc.’s investment management unit, which had $934 billion in assets at the end of 2014. “I think it’s a big risk and is one of the unintended consequences” of regulators trying to prevent another financial crisis, he said.

“If we had a major political event or something that caused rates to spike and traders needed to get out of the current position they have, and there was a lot of people that wanted to do that, I think it would be quite difficult,” Hunt, in Tokyo last week for various management meetings, said. He declined to comment on what measures Prudential is taking to lower liquidity risk, saying that information was sensitive from a competitive perspective.

This sort of decline is not limited to just fixed income. Have a look at this chart of NYSE trading:

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Volumes have collapsed. The reality of this decline is even worse than it looks. High Frequency Trading often results in double printing as the bots front run originating orders only to sell it back to the real buyer a penny higher. Whereas in an efficient market the buyer would simply purchase it from the real seller, in our topsy turvy world of HFTs dominated trading, this simple trade actually results in two trades, doubling the exchange volume. The true collapse in trading volumes is being masked by the myriad of HFT bots.

I often hear traders complain that this rally doesn’t feel right. This is the main reason – it is going up on air.

One day this whole charade is going to come unglued. I don’t know if the catalyst will be an eventual ignition of inflation due to the massive heaps of monetary fuel heaped on the global financial system, or whether it will collapse in on itself in a deflationary crash like 2008 again. But these prices aren’t real. Central Bankers are misjudging the liquidity of these financial instruments they are manipulating. They are just as naive as some 25 year old index arb trader bidding for too many ETFs on a slow summer afternoon. The problem is the Central Bankers won’t have a liquid S&P 500 market to lay off their risk. They will have already be long that asset too…


Weird chart for the week-end

I keep waiting for this next relationship to break down. I know there are often superfluous correlations that work for a while, but eventually prove to be nothing more than a statistical fluke. But this one seems to have more staying power than I would have ever imagined.

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Who would have thought that the collapse in yields could be so easily explained by the ratio of platinum to gold? I guess all those bond bears better be hoping that platinum gets a bid (or that gold sells off).

Thanks for reading and have a great wk-end,
Kevin Muir
the Macro Tourist

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