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Extraordinary Market Conditions Dry up Forex Liquidity
Wednesday, 17 September 2008 15:18:45 GMT  |  David Rodriguez, Quantitative Analyst
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Forex markets have seen historic volatility as of late, causing widespread panic in forex markets and drying up liquidity across a broad swath of asset classes. Indeed, our DailyFX 1-week volatility index is now at its highest since the inception of the euro—underlining financial market duress and fears that extreme price moves may continue through the coming days.

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Such market fears have had their clear effect on liquidity available across global dealing desks, as major financial institutions become unwilling to lend money and significantly scale back position risk across various assets. Such a dynamic can easily be seen in credit markets, as major financial players stampede into risk-free US Government Treasury Bills and simultaneously pull funds from interbank money markets.

The 3-month US Treasury Bill yield tells the entire story; an almost-unprecedented flight-to-safety has left rates at their lowest since 1954. The difference between the T-Bill rate and the equivalent money market yield subsequently stands at its worst levels since the infamous US stock market crash in October, 1987.

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Such extreme money market illiquidity only exacerbates market volatility, and the ongoing flight to quality makes market-makers in all markets unwilling to take risks. The net effect for traders is that bid/ask spreads across all traded instruments have widened considerably, and available liquidity at any price is significantly worse than in normal market conditions. Traders should be careful not to take undue risk in forex trading, as it has become increasingly clear that liquidity is scarce and they may be subject to poor price fills until conditions show substantial improvement. 

To contact the author of this report, e-mail drodriguez@dailyfx.com

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