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Managing Volatility in Short‑term Markets: The Global Liquidity Ladder

As financial conditions tighten, having the flexibility to manage and deploy portfolio liquidity is like having a ladder to higher ground.

In a storm, you want to be able to reach higher ground. Recent market volatility – sparked by concerns over interest rates, inflation, global trade, the tech sector and more – has many investors shifting toward more defensive portfolio positions.

Having the flexibility to manage and deploy portfolio liquidity amid rapidly changing and challenging conditions is like having a ladder to higher ground: It may help preserve capital while producing income.

The liquidity ladder

Soon after the financial crisis, PIMCO developed a concept, or image, that we called the “concentric circles of risk” to illustrate levels of credit risk in a world characterized by central bank quantitative easing (QE). In the center of the circle were the lowest-risk assets (for example, U.S. Treasury bills), while the outer circles represented more risky asset classes (such as corporate bonds and real estate).

Today, conditions are changing once again as central banks wind down their QE programs and move to normalize rates. In this environment of tightening financial conditions, we are carefully watching liquidity: We need to understand how it ebbs and flows, how it affects the pricing of risk assets and how it is managed by investors, who all have different objectives, time horizons and tolerances for short-term losses.

Our short-term portfolio management team conceptualizes liquidity conditions today using the image of a ladder, with market participants on different rungs depending on their ability to affect the pricing of liquidity, other market participants’ reaction functions and changes in the valuation of liquidity itself.

As an investor, it is crucial to know where you stand on the “liquidity ladder.” Conceptually, the ladder represents the broad but dynamic global liquidity system, and you may find yourself shifting up or down the rungs depending on changes in regulation, market conditions that affect the cost of liquidity, and most important, the type of investment strategy you adopt.

Liquidity “price makers” tend to have longer-dated investment horizons and fewer concerns over day-to-day fluctuations, and they stay near the top of the ladder. These currently include central banks, pension funds and regulated entities like insurance companies and money market funds. The less flexible “price takers” are near the bottom of the ladder; these may currently include hedge funds, passive ETF/ETN investors, market-makers and securities lenders. They can at inopportune times be forced sellers of otherwise attractive assets as they attempt to navigate the inclement conditions of a risk-off market. Our views on liquidity are affected by not only how far apart buyers and sellers are (bid-offer spreads) but also the risk appetites we observe from all of the participants on the ladder.

We believe that active portfolio managers can position themselves on the rungs as circumstances change or opportunities present themselves. Active investors may employ liquidity defensively and also as an opportunistic tool – seeking reward for assuming risk. Our active management approach attempts to anticipate changes in global liquidity and dynamically assess and reposition our various investment strategies on different rungs of the liquidity ladder as conditions warrant. In general, we aim to be sellers of liquidity when others are buyers and buyers of liquidity when others are sellers.

Our positioning on the liquidity ladder is key to adding value for investors. We aim to manage the divergent interests of price makers and price takers in ways that benefit our investors ‒ without only relying on “bets” on market outcomes, like interest rates, to outperform.

Up and down the rungs

In recent weeks, market participants have been continuously re-evaluating the function, price and use of liquidity, largely as a result of three altered market conditions:

  • Higher funding costs related to constrained seasonal changes and quarter-end illiquidity
  • A higher Libor rate and wider Libor/OIS spreads (the difference between Libor and the overnight index swap rate), which have increased the relative cost of funding for many banks
  • Changing supply and demand dynamics in the front end (i.e., more T-bill and short-dated corporate supply versus waning demand from corporate treasuries and foreign investors)

Just one example of active management in action in this environment would be to buy front-end zero- to 18-month corporate bonds when lower-rung participants are forced sellers. Providing they hold up well to independent credit analysis, many of these bonds can offer attractive yields of 2.50% and higher with limited interest rate exposure.

Active investors should constantly monitor the ebbs and flows of liquidity conditions. We suggest investors be prepared for a volatile ride, and bolster their portfolios with flexibility and liquidity to withstand brief but torrential rain showers when market sentiment turns negative while watching for attractive risk/reward opportunities. Know where you stand on the liquidity ladder so you can be prepared to seek higher ground.

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The Author

Jerome M. Schneider

Head of Short-Term Portfolio Management

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London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
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PIMCO Europe GmbH
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80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
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+39 02 9475 5400

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8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing a strategy.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

Reassessing Short-Term Strategies Amid Market Recalibration: Liquidity, Libor and the Fed
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