A man reacts after looking at an electronic stock board outside a securities firm in Tokyo, Japan. (Photographer: Noriko Hayashi/Bloomberg)

Goldman Sees `Financial Fragility' Rising Amid Market Breakdowns

(Bloomberg) -- Markets are becoming their own worst enemies, according to Goldman Sachs Group Inc.

The stock-market rout in early February that caused a spike in the Cboe Volatility Index is a symptom of growing “financial fragility,” or big swings in prices caused by breakdowns in markets themselves as opposed to changes in fundamentals, an economist at the bank wrote Monday in a note to clients. To make matters worse, Goldman says there’s reason to be concerned about liquidity drying up during periods when markets are distressed.

“Future liquidity disruptions may amplify price declines when the current cycle turns,” wrote Charles Himmelberg, Goldman’s co-chief markets economist. “Trading liquidity may be worse than it looks because trading volume in many major markets is increasingly dominated by more speed and less capital.”

The warning on fragility came days after the bank said in a note Friday that investors need to get used to lackluster returns as volatility picks up and stocks and bonds move more in tandem with each other. The selloff in U.S. technology stocks Monday sent the VIX futures curve into backwardation, a telltale sign that the market is under stress, as near-term contracts became more expensive than longer-dated counterparts.

New regulations and technologies such as computer-driven trading have caused a major change in how liquidity is provided since the financial crisis. Goldman says that while the shift has freed up capital for more efficient uses, it will also reduce liquidity when the cycle turns.

“This is why we think ‘markets themselves’ belong on the short list of late-cycle risks to which markets are potentially complacent,” Himmelberg said. “While the analogy is imperfect and our uncertainty is high, we see reasons to think that ‘liquidity is the new leverage.’”

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