Volatility

Well it's been a bouncy couple of weeks but slowly a sense of calm seems to be returning to most markets. 2 months ago it was agreed the Chinese stock market was in a bubble, so quite why the bursting of that bubble came as such a shock I'm not sure. But the bigger question to my mind is quite why so many markets moved so far and so fast.  The FX liberalisation certainly didn't help - it was interpreted by many - probably incorrectly - as a devaluation and as such a sign that the Chinese economy is in dire straits. While I agree with the sentiment re the economy I don't think that they were aiming for a devaluation. Firstly there's the "face" involved in admitting your economy is so screwed you need to devalue, and secondly I just don't think they're that bright.

But back to the moves......  I believe there are 2 factors contributing to the violence of recent moves. Firstly - the typical illiquidity of August when half of the city's traders and fund managers are on the beach. And secondly I think the blame can be partly ascribed to the regulators and their wonderful new capital rules. 

Banks simply don't want to hold assets on their balance sheets. Inventories are kept to a minimum, and money is made on the buy/sell spread of put through rather than positioning. This is worse in the summer when the managers are away and the juniors are terrified of being left holding the baby in a falling or rising market. Thus when faced with a wave of buyers or sellers they will move prices far and fast in order to find keen buyers or sellers on the other side. To make matters worse, the new market makers are in many circumstances hedge funds. These guys are not worried about customer relations, or regulator oversight, so they can be as aggressive as they like in their pricing. Having prices gap higher or lower doesn't bother them, and they love volatility as it allows them to pick up very underpriced assets and sell very overpriced assets. They have little incentive to calm markets. Volatility is their friend.

I believe these factors apply in all markets, and the volatility in equities, bonds and commodities over the last few weeks can be largely attributed to that. Now that the banks few remaining big swingers are back at their desks, and hopefully have brought their trading balls with them, liquidity might start to return and the volatility of recent days will fade. If not regulators might need to rethink some of their new rules.