By Dhara Ranasinghe, Saikat Chatterjee and Davide Barbuscia

LONDON/NEW YORK – Traders at the biggest markets around the globe are facing wild intra-day swings as well as shrinking deal size. Central banks swiftly withdraw stimulus measures. It is a small reminder of a two-year-old financial pandemic.

This week, the U.S. Federal Reserve reported that liquidity levels had “deteriorated further” than could be expected given volatility current levels. The report also highlighted poor conditions in the equity, commodity, and Treasury markets.

In March 2020, investors began to dump riskier assets. This triggered an economic crisis that prompted global policymakers in the United States to inject $15 trillion to assist them in recovering stability.

Markets that are unstable can reduce the central banks’ ability to effectively transmit their monetary policies. Some view the Fed’s words as a warning.

After 2008 regulations curbed market-making ability and risk-taking abilities of some of the largest banks in the world, liquidity was already becoming more restricted.

However, this year’s financial pinch can be attributed to the rapid rise in interest rates by central banks. This is combined with their attempts to trim balance sheets. These are swollen due to massive bond-buying schemes. Liquidity shortfalls on bond markets have made it even more difficult.

This is evident also in Cboe Volatility Index (also known as Wall Street’s fear gauge), which has risen 14% just this week. However, at 34 points the index is just below the peak of 90 that was reached in the COVID-19 financial crisis of 2020.

Central bank balance sheets set to get smaller https://fingfx.thomsonreuters.com/gfx/mkt/akpezybwgvr/cbanks1205.PNG

DEPTH DEPRESSED

The Fed will begin to reduce its bond holdings starting next month, leading likely to lower trading volumes.

Janus Henderson Investors’ bond portfolio manager Bethany Payne stated that the risk of bond market air pockets has increased due to high price swings and sudden volatility.

She stated that “Bond markets depth is still depressed year-to-date, as liquidity has been withdrawn from the system.” This was due to a combination of monetary tightening and inflation, Russia’s invasion in Ukraine, and Fed bond sales plans.

German 10-year bond futures on German bonds are one way to gauge the severity of the volatility. The average daily gap between high and low prices is greater than in any other year, Refinitiv data indicates. Bund volatility, however, was highest since 2020.

Volatility in German Bund futures has jumped https://graphics.reuters.com/GLOBAL-BONDS/zjvqkjqyxvx/chart.png

Similar results can be seen in the U.S. Treasury Market, worth $20 trillion. Steven Abrahams of brokerage Amherst Pierpont stated that this market resulted from Fed’s withdrawal of liquidity “by design”.

Abrahams stated that there are now more investors who aren’t certain where the curve will go next. This has led to some capital being taken out of the market and traders seeing this in jumpier yields throughout the day.

Diverse indexes show the state of market liquidity. Abrahams analysis shows that Treasury liquidity has been at its lowest since March 2020.

Goldman Sachs’ (NYSE) indicator, which uses inputs from 30 different markets, indicates that Treasuries have been the most liquid tightening market.

Cross-Border Capital’s other subsidiary, Cross-Border Capital (which the consultancy states leads markets by 6–12 months), is currently at a three-year high.

Bond volatility https://fingfx.thomsonreuters.com/gfx/mkt/akpezybrqvr/bond%20volatility.JPG

Be more careful

Greater volatility is evident in the currency markets. Average daily turnover of the top-traded pair of exchange rates, euro/dollar (from nearly 6000 in March) has dropped to 4,500 on EBS’ multi-dealer platform.

Low turnover may increase volatility. Refinitiv data has shown that the gauge of expected swings for the euro over a 1-month time horizon hit two-year highs exceeding 12%.

This can leave traders unable to trade larger amounts and may cause prices to drop a little.

The screens look quite normal. However, we are aware that it is difficult to trade large volumes. Chris Huddleston CEO of FXD Capital London stated that this will make trading more difficult as higher interest rates increase.

Suhail Shaikh (CIO Fulcrum Asset Management, London) estimates that volatility already falls between the 95th and the 90th percentile, depending on the asset class’s history.

Shaikh explained that part of market anxiety is due to the Fed’s loud talk about liquidity. This is unusual for the Fed.

He said, “So we’re just moving forward from not having to worry about ‘being more cautious’,” he continued.