In her speech on financial stability delivered at the Jackson Hole Symposium in late August, Chair of the Federal Reserve Janet Yellen expressed her concerns over the possible side effects of tighter regulation on financial markets. Some of her worries specifically echoed our view that central bank action and increased regulation have led to a fracture in secondary market liquidity in fixed income (see A New Paradigm for Fixed Income).

Yellen noted that, while corporate bond bid-ask spreads are low and issuance has been strong in recent years, some financial market participants have expressed concern about the ability to transact large volumes at a low cost. She notes that “large dealers appear to devote less of their balance sheets to holding inventories of securities to facilitate trades and instead increasingly facilitate trades by directly matching buyers and sellers.” We have been making this same point for some time now as we believe that increased capital requirements have discouraged banks from their traditional inventories-holding, market-making and liquidity-providing roles.

Yellen also noted that “algorithmic traders and institutional investors are a larger presence in various markets than previously, and the willingness of these institutions to support liquidity in stressful conditions is uncertain”. We believe that recent examples suggest that these market participants are unlikely to provide the needed liquidity in times of stress. The most extreme example occurred in mid-2015 when German Bund markets seized up, pushing yields from five basis points to over 100 in a matter of days. Anecdotal evidence suggests similar disruption as the results of last year’s US Presidential election came in, especially in emerging markets. Similarly, the dislocation in the Brazilian fixed income market in May this year, following speculation relating to evidence of corruption by President Temer, was also a result of fractured liquidity. Fractured liquidity leads to sharp increases in prices and transaction-cost volatility for investors, who are not being compensated for such risks.

In her speech Yellen suggested that “there may be benefits to simplifying aspects of the Volcker rule, which limits proprietary trading by banking firms, and to reviewing the interaction of the enhanced supplementary leverage ratio with risk-based capital requirements.” Nevertheless, she also added that the new regulatory framework has made broker-dealers more resilient to systemic shocks.

Overall, an increasing mainstream focus on fractured liquidity issues continues to underscore our view that investors require a new portfolio construction paradigm, in particular one that abandons flawed market capitalisation-weighted benchmarks which reward leverage, in favour of low-turnover strategies anchored in fundamental issuer quality in order to mitigate underlying default risk in portfolios. We discussed the shortcomings of market-cap benchmarks and how these are amplified in the current environment in a recent article published by IPE.