Didier Le Menestrel

A drunk market?

JP MORGAN’s CEO Jamie Dimon is delighted: the company that he heads has reported record earnings of $22bn for 2014. This figure is all the more spectacular in that the bank was obliged to pay various fines totalling $25bn over 2013 and 2014. Goldman Sachs is on a similar path and a few fines did not prevent the bank from reporting healthy earnings for the past year and a record Q1 2015 at $2.7bn. While the 2008 crisis has not been forgotten, the US financial sector is now back on track. Within a few years and with the massive help of the Federal Reserve, the US banking industry has moved from a situation of “back to business” to “business as usual”, and is now doing “better than usual”.

“Better than usual” is unusual and while rejoicing at the company’s results, Jamie Dimon underscored the risk of excessive volatility on the markets. Could this be seen as exaggerated paranoia just as the stockmarkets have moved onto a steady uptrend? Not so sure. Indeed, two recent market accidents were reminders that volatility peaks can be very brutal. Firstly, during trading on 15 January the Swiss franc fluctuated by 35% in less than half an hour after the Swiss National Bank abandoned its peg. Secondly, on 15 October 2014, the yield on 10-year US bonds plummeted from 2.21% to 1.86% in just a few minutes, before returning to normal just two hours later.

In the bond market especially, a strange balance is being created. The ever-increasing liquidity provided by central banks is going hand in hand with a weakening in liquidity on the markets welcoming it. The word “liquidity” actually designates two realities: the quantity of money in the first case and the ability of players to provide market prices in the second. Market liquidity can increase in a quantitative manner by observing supply and demand for a given asset. Remaining with US 10-year government bonds, the three best aggregate demand and supply pairs are estimated to have represented $500m in 2007. This figure has fallen to $125m in current markets. A large buyer or a large seller will therefore have more difficulty in finding a counterparty today than they did in the past.

The same trend is visible in the corporate bond market. Estimates suggest that market-makers’ positions have been quartered and here again, liquidity is drying up. The reason for this decline lies in the regulatory backdrop: the reality is more complicated and post-2008 regulations have had the effect of providing a wide framework for bank risk profiles in a new environment that has clearly reduced their ability to supply prices and offer counterparties to market players.

In view of the policies implemented by the European Central Bank (barring a massive Greek slip-up), there is little chance of seeing eurozone players testing the markets’ absorption capacity in coming months. So why are we looking for the emergency exit when the orchestra is still playing?

Over the medium term, there is a high risk of seeing a repeat of accidents such as those of 15 October with a surge in capital masses and price providers with reduced capacity…. We should then remind ourselves of something stated by a Salomon Brothers’ trader: “The market is extremely liquid except when you want to trade”.

Didier Le Menestrel