Analysis: Traders set for wilder swings as rising rates fuel volatility

A specialty trader works on the floor of the New York Stock Exchange, August 21, 2015. REUTERS/Brendan McDermid

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LONDON/NEW YORK, May 13 (Reuters) – Traders in the world’s biggest markets are facing wild intraday swings and shrinking trade sizes as central banks swiftly withdraw stimulus, in a small-scale reminder of a financial crisis caused by the pandemic. seizure barely two years ago.

The U.S. Federal Reserve said in a report this week that liquidity had “deteriorated” more than would be expected at current levels of volatility, with noticeably poor conditions in Treasury, commodities and shares. Read more

The onset of the coronavirus pandemic triggered a market meltdown in March 2020 as investors dumped riskier assets, prompting global policymakers to inject a total of $15 trillion, the equivalent of more than a sixth in the world economy, to help them regain stability.

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If markets are too volatile, the ability of central banks to effectively transmit monetary policy is reduced and the Fed’s wording is interpreted as a warning by some.

Liquidity had already been progressively more constrained after post-2008 regulations limited the market-making and risk-taking ability of the world’s largest banks.

But this year’s pinch is due to rapid interest rate hikes by central banks and their efforts to shrink balance sheets bloated by huge bond-buying programs, with liquidity shortages now particularly acute on bond markets.

It’s also evident in the Cboe Volatility Index (.VIX), known as Wall Street’s “fear gauge,” which is up 14% this week alone. But at just over 34 points, the VIX remains below highs of nearly 90 hit at the outbreak of the COVID-19 crisis in 2020 and the global financial crisis in 2008.

Central bank balance sheets are expected to shrink

DEPRESSED DEPTH

Starting next month, the Fed will begin selling its bonds, which will likely result in even lower trading volumes.

Bethany Payne, bond portfolio manager at Janus Henderson Investors, said “the risk of hitting air pockets in the bond market has increased” from the possibility of sudden large swings in prices.

“Bond market depth remains depressed year-to-date as liquidity is taken out of the system,” she said, citing the combination of monetary tightening, inflation, Russia’s invasion of Ukraine and plans to sell Fed bonds.

An indicator of the extent of volatility are German 10-year bond futures, which are showing an average daily spread between high and low prices that is higher than any year in recent years. five years, according to Refinitiv data, while Bund volatility in March was the highest since 2020.

Reuters Charts Reuters Charts

The situation is similar in the $20 trillion U.S. Treasury market, which Steven Abrahams of brokerage Amherst Pierpont says is the result of “Fed liquidity withdrawal” by the Fed.

“There are more investors who just don’t know where the curve is going to go next, who’s taken some capital out of the market, and traders are also seeing it in the form of more jerky movements in yields over the course of the day,” Abrahams said.

Various indices illustrate the shape market liquidity is in, with Abrahams’ analysis showing that Treasury liquidity is at its tightest level since March 2020.

And a Goldman Sachs indicator based on data from more than 30 different markets shows Treasuries leading the recent liquidity crunch.

Another from Cross-Border Capital, which the consultancy says leads the markets 6 to 12 months, is at its lowest level in three years.

bond volatility

‘BE MORE CAREFUL’

Greater volatility appears to be filtering into the forex markets, where the average daily turnover on the world’s most traded currency pair, the euro/dollar, fell to 4,500 trades on the multi- EBS dealers, compared to nearly 6,000 in March.

Weaker revenue may increase volatility, with a gauge of the euro’s expected one-month-ahead swings recently hitting two-year highs above 12%, according to Refinitiv data.

This often leaves traders struggling to execute larger trades and can result in a small number of trades to fluctuate prices.

“If you look at the screens, they are relatively normal. But we know that if someone wants to trade a large size, that depth (of the market) will be tested,” said Chris Huddleston, CEO of the company. brokerage FXD Capital in London, adding trading would become more difficult as interest rate hikes accelerate.

Suhail Shaikh, CIO at Fulcrum Asset Management in London, believes that volatility is already between the 90th and 95th percentile in the context of the asset classes’ own history.

But part of the market jitters is because “risk managers are pointing out that the Fed has been making a lot of noise about liquidity, which is not common for the Fed,” Shaikh said.

“So we move on from there without worrying about ‘being more careful,'” he added.

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Reporting by Dhara Ranasinghe, Sujata Rao, Danilo Masoni and Saikat Chatterjee and Davide Barbuscia; Editing by Sujata Rao and Alexander Smith

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