November 20, 2015 / 9:18 PM / in 3 years

Investors warn of greater volatility from liquidity crunch

NEW YORK (Reuters) - Financial markets face greater price swings in the coming year as anticipated interest rate hikes from the Federal Reserve exacerbate an environment of reduced liquidity, top investors and strategists said this week.

Mohamed El-Erian, chief economic advisor for Allianz, speaks at the Reuters Global Investment Summit in New York, November 17, 2015. REUTERS/Brendan McDermid

Speakers at the Reuters Global Investment Outlook Summit in New York said that the lack of liquidity, or greater difficulty buying and selling securities, that has contributed to dramatic asset price gyrations in recent years could worsen given the Fed’s process of tightening U.S. monetary policy.

“The reason why volatility is going to be higher ... you don’t have this huge blanket of liquidity in the world like you had for the last three or four years,” said Rick Rieder, chief investment officer of fundamental fixed income for BlackRock, which manages $4.5 trillion.

Rieder noted that currency reserves in China were declining after several years of a reserve buildup in the world’s second-biggest economy that had resulted in money entering the U.S. financial markets in “huge size.”

Scarce liquidity, partly as a result of curbs on banks’ ability to take risks and an increase in technology-driven trading, has contributed to events such as the Dow Jones industrial average losing more than 1,000 points in the first few minutes of trading on Aug. 24 and the Treasury market “flash crash” on Oct. 15, 2014.

“There is just not as much two-way flow in the markets as we saw pre-crisis, and I don’t think that’s getting better in 2016,” said Erin Browne, portfolio manager at Point72 Asset Management.

“Particularly where the Fed’s going to be raising rates, there is less liquidity in the market, there is the opportunity for more gap risk next year,” she said in reference to the risk of sudden declines in prices, and with it, sharp widening in bid-ask spreads.

Some investors remain under the illusion that the Fed is going to reassure markets during periods of distress, said Mohamed El-Erian, chief economic adviser at Allianz SE (ALVG.DE).

“The market is comfortable that whenever we hit a hiccup, the Fed is going to come back in,” he said. “It’s very deeply embedded that central banks are our best friends forever.”

He noted that, even though the U.S. central bank “wants to” normalize rates, people have expressed in recent weeks that they still believe that the Fed will engage in another round of quantitative easing. He reiterated, however, that low liquidity remained a risk and that there was a 30 percent probability of a U.S. recession in 2017.

“We still somehow believe that liquidity will be available to us to reposition,” he said.

Reporting by Sam Forgione; Editing by Jennifer Ablan and James Dalgleish

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