I am doing a interview piece for Real Vision today, in which I will ask a number of veteran market players what they’re seeing as the coronavirus scare takes full form. So, in preparation for that, I am writing this piece, because I think market structure issues could soon be at play.
Signs of a risk-off mood
As I write this, the headlines say Dow Futures are down over 370 points and the US 10-year yield has hit another record low below 1.29%. US President Donald Trump attempted to calm markets yesterday, saying that the risk from the coronavirus was “very low” and that the US was “very, very ready” to face any threat. Markets aren’t buying it.
But not only are the Treasury and equity markets signalling risk-off, so too are oil, gold and currency markets. US crude futures were down 3% to $47.27. Gold futures were up 0.7% to $1654 as investors flocked to safe haven stores of value like the Japanese Yen and the Swiss Franc. In the US, municipal bonds are also catching a bid as investors seek safe haven assets.
The questions now go to how long this can go on before market structure and liquidity issues become core.
Since the financial crisis of 2007-2009, the structure of many markets has changed dramatically. For example, in equity markets, passive investment strategies have become a dominant factor. In money markets, collateralized repurchase agreements now dominate the market for overnight liquidity. These changes have not been battle-tested enough though. And, in market downdrafts, this fact could amplify volatility and downside risk.
A couple of weeks ago, I mentioned the fact that the Fed is looking into ways to ‘fix’ the repo market, so that should a liquidity crisis occur, the market won’t freeze up. A standing repo facility is one way to get there. But Fed insiders leading the policy implementation like Randal Quarles are not sold on this fix. So, the Fed has dragged its feet on a solution. Repo could be tested. Last week, I wrote that the downside risks of coronavirus are mounting and said that “even though I think Quarles is telling us that a Standing Repo Facility is coming eventually, he is also not supportive of a Standing Repo Facility yet. That tells you that changes at the Fed to gear up for a potential liquidity crisis are not going to happen overnight. And that means the repo market is still vulnerable, dependent on ad hoc Fed decision-making to avoid hiccups that significant; tighten financial conditions or lead to a crisis.”
In equity markets, the vulnerability is what I would call automation. And it’s two-fold. One problem is the mechanistic way that ‘liquidity’ is added to the market via passive investment strategies. By that, I mean that most ordinary investors are convinced that timing the market doesn’t work. So, the best approach is to simply allocate funds to the market at all times in a mechanical way, irrespective of whether prices are rising or declining.
This approach works when markets don’t have major downdrafts. In fact, it may insulate markets from corrections. On the other hand, animal spirits have not been waved away by passive strategies. If event risk – like the coronavirus – overwhelms the passive insulating factor, you will get equity market withdrawals that amplify downside risk.
I spoke to Thomas Peterffy, the founder of Interactive Brokers, a couple of weeks ago for Real Vision (link here). His view is that high-frequency trading has changed market structure in a way that makes the market vulnerable to flash crashes. He says ” there is no chance for somebody to withdraw a limit order, they will not be putting it in, and therefore there won’t be anything to stop it and it may go down 10%, 20, 30% and then the people who are carrying big positions on leverage, suddenly become unable to pay for the losses, and then the whole thing may come down as in the time of Lehman Brothers.”
Above I didn’t even mention what I have been calling fake liquidity where exchange-traded funds of illiquid assets like high yield bonds are traded as if the underlying market isn’t illiquid. But there are tons of market structure issues like this.
In a case where the coronavirus becomes a pandemic – and we are on the cusp of that right now – these market structure issues are going to be very relevant. I think they will add liquidity bottlenecks that cause fear and add downside risk to the markets. This is great for safe haven assets – gold, the Swiss Franc, Japanese Yen, and US Treasury bonds. But, it risks further event risk in the form of a liquidity crisis. And in an environment of declining global growth, you would see downside economic scenarios amplified by tightening financial conditions.
Right now, I am reading about what’s happening in Italy (WaPo link here). And it is a portend of what’s likely to happen right across Europe – and eventually even in the United States. Even Janet Yellen is talking about it in these terms (Bloomberg News link here).
The worst case scenarios begin with the effects of lockdown and quarantine like we see in China making its way to countries like South Korea and Italy and then the rest of the world without arresting the spread of the coronavirus. That almost certainly ends in a global recession. And it will trigger all of the animal spirits that cause liquidity to evaporate in financial markets, triggering a major tightening of financial conditions and eventually bankruptcies.
Watch what happens in Italy and, particularly South Korea, for signs of what kind of approach health officials take and what impact it will have on the economy.
South Korea is important because more new coronavirus cases were reported in the last day there than in China. And they are taking a lockdown and quarantine approach, but one that is more like what we can imagine happening in other OECD countries.
Italy is important because it’s economy is already on its knees. And what happens there will be instructive regarding how an economy that is economically vulnerable fares on the front lines of this epidemic.
I fully expect the coronavirus to dominate headlines for the weeks and months ahead – and not in a good way.