Liquidity – “degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Ability to convert an asset to cash quickly. Also known as marketability.” – Investopedia
As the U.S. Federal Reserve prepares to raise the Fed Funds rate for the first time in almost 10 years, there has been an uptick in nervousness about the potential fallout from this move in global financial markets. The biggest fear is not about a growth slowdown – it’s about heightened volatility and lack of liquidity especially in bond markets. Think back to the taper tantrum last October 15th when yield on the benchmark 10 year US Treasury bond nose-dived to 1.87%, the lowest level since May 2013. In an April 15th 2015 report, the Telegraph highlighted the International Monetary Fund’s (IMF) concern about a repeat of this sudden loss of liquidity in bond markets when the US Federal Reserve raises interest rates. The IMF warned in its Global Financial Stability report that “Lower market liquidity and higher market leverage in the US system increase the risk of minor shocks being propagated and amplified into sharp price corrections.” Also, “A sudden shift in market views that unwinds compressed premiums and sends yields higher could trigger a market liquidity shock.” Essentially, if investors decide they no longer want to own bonds and want their money back, prices will collapse and yields will shoot higher. Also, should sellers outnumber buyers, the ability to sell bonds and convert to cash can vanish. As Reuters pointed out in its May 1st 2015 article, it is near impossible to measure liquidity accurately. Its scarcity is only exposed during a crisis.
The ability to liquidate asset positions with ease, especially in bond markets, can no longer be taken for granted.
The two main reasons cited for the decline in liquidity are:
- regulations that require banks to raise their capital bases and cut bond inventories. Deutsche Bank says that primary dealers now hold about US$50 billion of US corporate bonds versus US$300 billion pre-2008 crisis. Contrast this with indications that the amount of outstanding US high grade corporate bonds has grown from US$2.8 trillion in 2008 to US$5.0 trillion. Banks’ ability to act as market makers and shock absorbers in the secondary fixed income, currency and money markets is dramatically restricted. Bank dealers are now less able to match buyers with sellers, provide liquidity and smooth market volatility.
- search for yields by fund managers. This has led to a massive surge in demand for bonds. A Financial Times report on April 30th 2015 indicates that more than 70% of corporate credit was bought last year by mutual funds. In its recent report, the IMF worries that large inflows of money into mutual funds have “provided an illusion of liquidity in credit markets”. But, this is no protection in the face of a major shock.
The US Federal Reserve echoes the IMF’s concerns. Reuters reported on April 23th 2015 that the Fed is increasingly concerned about the booming asset management industry’s ability to withstand a run of redemptions in a financial crisis. The issue here is whether certain funds held by individuals and institutions will have enough underlying assets to back investors cashing out in a panic. Investors and the economy would be subject to sharp price swings if liquidity is absent. Liquidity mismatch considerations have, according to Jay Hooley, State Street Bank’s (SSB) CEO, caused leading asset managers to hoard more cash than required. SSB recently announced a service that allows asset managers to assess their vulnerabilities and liquidity needs to encourage them to optimize liquidity across their portfolios and minimise cash holdings.
The Fed and IMF have been joined in their concerns about liquidity by the Bank for International Settlements, Bank of England, BlackRock, and JP Morgan. The implications of impaired market liquidity should not be taken lightly.