Liquidity lessons from the rates market in 2022

Published on 16 December 2022

While rising rates can be very positive for macro investors, the speed of rate rises in 2022 has created serious liquidity challenges. Not only has dealer risk appetite been tested, in markets like UK gilts there have been a perfect storm of conditions – including leverage and decades of low central bank rates- which have punished government bond holders.

We review rates investment and trading in 2022 with James Athey, investment director at Abrdn, who analyses the gilt crisis in late September, sell-side liquidity provision and the best approach to portfolio optimisation for macro portfolio managers this year.

Transcript of interview:

Dan Barnes: Welcome to Trader TV – your insights into institutional trading. I’m Dan Barnes.

Today we’re going to have a look back at the rates markets this year and notably the turmoil that occurred in gilt markets in the UK. Joining me to do this is James Athey, investment director at Abrdn.

James, welcome back to the show.

James Athey: Hi Dan, great to be here.

Dan Barnes: So on a day to day basis, what did that turmoil and the gilt markets look like?

James Athey: Messy. It’s fair to say that those few days at the end of September, it was difficult to find a functioning gilt market. The speed of the moves that we were seeing in yields obviously has the effect of discouraging participants from engaging with the market.

What we’ve learned since those few very dramatic days was obviously that there was a lot of selling and that therefore really was the primary cause. Other investors then disengaging, meant that that became a self-fulfilling prophecy. It was difficult to find prices, it was difficult to execute any sort of business. It really was a complete breakdown of the market, I have to say.

Dan Barnes: And how split was the market between those forced sellers and opportunistic buyers?

James Athey: In my experience, when you have that extreme a market dysfunction, it’s very rare, but in the teeth of battle you’ve got many opportunistic players. Often the phrase that we use in markets is catching a falling knife. But I think episodes like this, it’s more like stepping in front of a moving steam train.

So I think very much forced activity dominated during those most dramatic days at the end of September and then again at the beginning of October. I think since then we’ve seen a greater degree of opportunistic buyers looking at those yield levels and really seeing those as attractive. And I think that included the retail spectrum. To be honest, the data suggests that retail buyers were significant when it came to gilts in the aftermath of that episode.

Dan Barnes: Could you characterize perhaps the liquidity challenges that exist between the buy and sell-side in a situation like that?

James Athey: In normal times, the mid-market price is the point at which willing buyers and willing sellers meet. The episode that we’ve just seen here, as I say, it was one of disengagement and a complete lack of participation. And so market makers, the big banks, the big broker dealers who generally are using their balance sheet to make markets, come what may.

In an episode like this, they will be looking at their screens which are facing the IDBs that are going into dealer brokers and seeing very few prices, very wide prices. That obviously has a significant impact on their willingness to make prices at all or to make prices that are anywhere near mid-market. And again, that then has a cascading effect through the market.

Dan Barnes: In a rising rate environment, macro funds can look particularly attractive. But what can the portfolio managers do to position themselves to best take advantage of that?

James Athey: Yes, I think not necessarily just a rising rate environment, but it’s certainly one where it’s the big macro drivers which are causing rates to go up. I mean, I would have called this really something more orthodox than we’ve been accustomed to for much of the post-crisis period.

Growth was strong, inflation was very high. Central banks were being forced to tighten policy and do so significantly and rapidly. That’s a fairly orthodox situation, even if it was extreme in magnitude. But yes, macro hedge funds certainly had a great year this year. Basically by bringing along the dollar and selling everything else they possibly can is not always as straightforward as that at the time.

In advance of some of these changes, I don’t think many of us saw the Russia Ukraine situation coming. I don’t think many of us expected the ECB to be hiking 75 basis points or the Riksbank to be hiking 100 basis points. I think next year we’re likely to see a very different environment. It will obviously be interesting to see how the macro players get on as the winds shift once again.

Dan Barnes: Are there any best practices that you’d like to see sell-side firms put forward?

James Athey: I do think juniorisation of trading desks in general on the sell-side has had a somewhat deleterious effect on market liquidity. Certainly banking regulation and restrictions around balance sheet usage have definitely impacted market liquidity in general. But to be honest, I don’t think the episode really was a failing of the sell-side role as a liquidity provider. I don’t think it was an obvious failing of bank regulation.

My major lesson really to be taken from that episode is more to do with leverage in the behavior of liability-driven investment schemes and pension funds. These really are the ultimate in slow moving, long term fundamental investors. They really should have the ability to warehouse all kinds of short term liquidity and volatility because they have liability stretching 20, 30 or more years into the future. The fact that they were put into a situation where they felt the need to engage in such significant leverage because central banks had taken rates to zero and kept them there for so long, that really is the biggest lesson for me.

Interest rate cuts are not a free lunch. A zero rate policy is not a free lunch, and quantitative easing is, in my opinion, still highly questionable in terms of its benefits vs some of these unforeseen costs and impacts on financial markets. If we are going to learn a lesson I would like us to take from this that monetary policy needs to be on a much more sound footing in the medium term relative to what we’ve seen post-crisis.

Dan Barnes: And so are there any lessons individual firms can take away from this? Or is perhaps this something that requires a market wide review?

James Athey: The fact that you had such high inflation at the time, the Bank of England that was dragging its feet with respect to monetary policy in advance of what we knew was likely to be a very expansionary fiscal policy. The way in which the government communicated and of course, all exacerbated by liability-driven investment leverage issues. That really is a kind of perfect storm. And so setting up and optimizing the system for a situation like that is never wise.

I’m sure banks would be looking at their own trading books, but so far we’ve not heard stories really of significant loss from the sell side. It doesn’t feel like it was a situation in which they got themselves in trouble or anybody’s taken any massive trading losses. There may well be specific lessons. I’m afraid that it would be speculative for me to be able to sort of delve into those.

Dan Barnes: James, that’s been great. Thank you so much.

James Athey: Thanks, Dan.

Dan Barnes: I’d like to thank James for his insights today and of course, you for watching. To catch up on our other shows or to subscribe to our newsletter, go to TRADERTV.NET.