Goldman Fears "Prolonged Periods Of Financial Instability" Due To Slumping Market Liquidity

Having "killed" the Japanese bond market - the largest in the world - through never-ending meddling in market forces, it seems the impact of the world's central bankers' egos on basic market structure is becoming more and more widespread (and concerning).

As The Wall Street Journal recently noted, worsening liquidity comes as banks have reduced inventory of riskier assets and investors more closely track bond indexes, making it harder and harder to buy or sell when they want (let alone when they need)...

The liquidity problem has been worsening for years. Investors say it began nearly a decade ago, when post-financial-crisis regulation prevented banks from trading for themselves, and forced them to hold larger amounts of capital - thereby shrinking their inventory of riskier assets. This, in turn, reduced banks’ ability to serve as intermediaries between buyers and sellers.

“It’s like going into a grocery store and there’s nothing on the shelves,” said Jeffrey Cleveland, who said liquidity is a hot topic among the traders he confers with regularly as chief economist at Los Angeles money manager Payden & Rygel.

Even in the world’s deepest bond market, U.S. government debt, liquidity has worsened as trading activity can’t keep up with booming supply. The Federal Reserve’s network of primary dealers, which are required to bid at government bond auctions, reported $455 billion of daily Treasury debt trades for the seven days ended April 11. That figure has declined since 2007 - even though since that time, tradable Treasury debt has more than tripled.

The recent spike in market volatility “suggests there is good reason to worry about how well liquidity will be provided during episodes of market duress,” Charles Himmelberg, a Goldman Sachs Group Inc. economist wrote in a recent report.

This could contribute to price declines and possibly prolonged periods of financial instability.

With less confidence that they can raise cash to make new purchases or meet client redemptions, WSJ  notes that some investors have sold more than they initially intended for fear that they might not be able to sell at a future time.

“You might as well sell when the liquidity is there” because it might not be there another day, said Marc Bushallow, managing director of fixed income at Manning & Napier.

This year’s volatility has even hampered liquidity in the popular E-mini S&P 500 futures on the Chicago Mercantile Exchange, a derivative product widely used for betting on the stock market’s direction or hedging against market swings. In the most active E-mini contract, the average number of contracts available to be bought or sold at the best price slumped from more than 500 in October to just 96 in March, according to MayStreet LLC, a data-analytics company.

The number of contracts that can be bought or sold at the best price has thinned out as vol picked up this year...

In the options market, liquidity has deteriorated as new exchanges and more products have diluted trading, analysts say. Liquidity for options in February was worse than in August 2015, when China’s unexpected devaluation of the yuan sent markets reeling, according to Option Research and Technology Services.

The average size behind buy and sell quotes for US listed options has shrunk dramatically this year amid heightened volatility...

Finally, WSJ concludes, another reason for less liquidity: many investors are more closely tracking bond indexes, creating large demand for newly issued bonds but little appetite for older ones.

The problem with investors managing against an index is that “everyone is chasing the same stuff,” Payden & Rygel’s Mr. Cleveland said.

As more market participants throw in the towel on rigged, centrally planned markets, the result will - no could - be a further loss of market function, and a guaranteed crash once the BOJ and other central banks pull out (which is why they can't).

As the Nikkei politely concluded, "if the bond and money markets lose their ability to price credit based on future interest rate expectations and supply and demand, the risk of sudden rate volatility from external shocks like a global financial crisis will rise."