Jefferies Sees `Substantial' Liquidity Void Growing in Markets

  • Leaders tell clients in letter of potential `inflection point'
  • `Low inventories are being taxed with extreme volatility'

Regulatory pressure on big banks to reduce risk has left markets more vulnerable to price swings fueled by emotions and the movements of small investors, according to Jefferies Group.

Forcing Wall Street firms to cut inventories of the assets they help customers trade has “engendered a substantial and growing void in liquidity,” the investment bank’s leaders, Richard Handler and Brian Friedman, wrote in a quarterly letter to clients. The pair outlined global developments that could potentially cause an “inflection point,” in which markets dramatically change direction, during the coming year.

Market makers have pulled back on “everything from high-yield bonds, European sovereign debt, bank loans, distressed securities and equities,” they wrote. “Incredibly low inventories are being taxed with extreme volatility and the challenges of a market that is often driven by emotions, rather than fundamentals.”

Handler, who also leads Jefferies’s parent company, New York-based Leucadia National Corp., and Friedman, who heads the firm’s executive committee, said they weren’t predicting disaster so much as raising awareness of areas drawing their concern -- also including interest-rate moves and the commodities slump. They said they were “quite optimistic” for 2016, because the financial system and U.S. are healthy. One lesson of the 2008 financial crisis, they noted, is that leaders can cooperate in times of stress and do what’s necessary to put things back on track.

‘Open Eyes’

Still, they detailed forces undermining market calm. The Financial Industry Regulatory Authority’s Trace bond-price reporting system, for example, seems to be exacerbating price swings for some illiquid securities, they said. Small investors are increasingly trying to react in real time to news and social media. Exchange-traded funds and high-frequency traders are adding complexity.

“To us, all these factors may add up to a recipe to turn a small inflection point a lot worse, but we acknowledge we could be 100% wrong (and hope we are),” they wrote. “We are merely watching with open eyes and trying to learn from history and today’s reality.”

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