Jay Sivapalan, Head of Australian Fixed Interest at Janus Henderson, provides his views on the liquidity challenges affecting markets and how central banks will need to do more through the COVID-19 crisis.

Post-GFC regulations hindering liquidity

Central banks have an acute awareness of liquidity in the post-Global Financial Crisis (GFC) era where intermediaries such as banks typically have much smaller capacity or inventory on balance sheets.

Banks’ ability to broker for the investment community has drastically diminished and is an unfortunate side effect of the post-GFC regulations that came into effect for banks and their trading activities.

These developments, coupled with an exogenous shock, are almost the perfect storm that central banks and regulators feared. It is fair to say that a major contributing factor of the veracity of the market sell-off, in particular risk assets such as corporate debt, has been lacklustre liquidity and poor price discovery.

One of the biggest risks that market participants are facing at present is a liquidity freeze, largely because the banks are not there to provide pricing and liquidity. That’s not to say there isn’t a weight of money waiting to invest and wanting to buy. We’re one in that category; but many like us are choosing not to spend cash reserves all at once.

What can central banks do?

Central banks cognisant of this dynamic are looking for ways to provide much needed liquidity facilities. A number of new categories of securities have become repo eligible, meaning investors can actually sell them to the Reserve Bank of Australia (RBA) and purchase back at a later date to access near-term funding. We expect broader liquidity-focused measures to be announced in the coming weeks.

So while liquidity is problematic, central banks are going to be pumping a lot of liquidity into the system. It wouldn’t surprise us if in the coming month or two the RBA starts acting more like other central banks, such as the ECB previously.

Taking an extreme example, the Bank of Japan as part of its remit can even buy equities. The point here is that central banks, including the RBA will need to be innovative and stand ready to act in order to support liquidity. We feel this is the most important tool for the weeks and months ahead, where cash rate settings are a secondary consideration.