JPMorgan says liquidity conditions are making markets vulnerable

Bloomberg reports that markets are still struggling to restore liquidity after the Covid-19 meltdown and that may leave them exposed to new shocks, according to JPMorgan Chase & Co.

“Liquidity conditions have improved considerably, though not fully, and overall functioning has mostly been restored, but markets remain in an unstable equilibrium and vulnerable to shocks,” strategists including Joyce Chang, Nikolaos Panigirtzoglou and Marko Kolanovic wrote in a report.

Strategists have been cautioning on tight liquidity and fragility for some time, citing everything from the growth of passive investing to high-frequency trading as factors that could exacerbate market stress, particularly when volatility spikes.

“Credit and bonds seem to be closer to a full recovery in terms of liquidity, while equities and FX still seem to be some way from pre-correction levels,” the report said.

Credit markets have seen an improvement in liquidity metrics for both cash and derivative products, and Federal Reserve programs have “materially” supported the high-grade bond market recovery, the report said.

In equities, central bank intervention reversed a negative feedback loop between volatility and forced selling by some investors, so things are calmer than they were before. But market depth for E-mini S&P 500 futures remains about 60% below levels seen before the March correction, the strategists said.

Liquidity in the currency market is “skating on thin ice,” according to the report, which said that even as volumes surged on recent risk aversion the market remains fragile, with low depth and stretched spreads.

In Treasuries, the Fed’s record asset purchases have restored “some semblance of normalcy” in market functioning, JPMorgan said.

“While liquidity has improved markedly, Treasury duration supply is set to increase 40% in the second half of the year, and regulatory relief is temporary, leaving the Treasury market susceptible to another bout of reduced liquidity,” the report warned.