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July 26, 2018

News in Charts: Falling Market Liquidity – Danger for Risk Assets?

by Fathom Consulting.

by Fathom Consulting.

Fathom Consulting’s proprietary liquidity indicator, the FLIQ, points to a drop in market liquidity amid Federal Reserve rate hikes and quantitative tightening. The FLIQ is calculated by looking at the price of closed-end funds (CEFs). It is designed to provide a timely and intuitive assessment of aggregate financial market liquidity risk. By their nature, CEFs will tend to trade at a discount to the value of the underlying assets (their net asset value, or NAV). By measuring the size of this discount, relative to its historic average, we can obtain an estimate of the abundance, or the scarcity of market liquidity

At the end of June 2018, the bulk of the assets held in CEFs were concentrated in either equity or fixed income. Meanwhile, North American and globally diversified funds dominated the geographical focus, though emerging market (EM) assets were also an important share of the total. The breakdown by asset class is not uniform across regions. For example, US assets held by CEFs are skewed towards fixed income, while EM assets held by CEFs are skewed towards real estate.

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The FLIQ is provided as a z-score. That is to say, it measures, in units of standard deviations, the current discount to NAV of a set of CEFs relative to their historic average discount. A reading below zero indicates that the discount is unusually large, and liquidity unusually scarce, and vice versa. A number of significant systemic liquidity events can be recognised in our chart below.

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After peaking last summer, the FLIQ declined to a little below its historic average, as it became clear that the Fed would continue with its rate hiking cycle, and as concerns about the outlook for Chinese growth increased. Since then, the yield on a ten-year US government bond has increased by 60 basis points, while financial markets have been associated with bouts of heightened volatility.

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Looking ahead, trends in fixed income liquidity tend to lead trends in the liquidity of other asset classes. This may reflect the importance of US assets within our fixed-income liquidity measure. As rates continue to rise, and as QE unwinds, the positive portfolio rebalancing effects that have supported markets since 2009 might go into reverse and create broader asymmetries in risks across assets.

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