We have noted here on the blog that the IMF blog has recently issued a warning about the possibility of a sudden, unexpected drop in liquidity in key markets. On the surface, this seems odd given all the massive liquidity that has been created by the various QE programs around the world. In this article Nouriel Roubini explains the problem and provides three reasons why liquidity could be a concern. Below are a few quotes from his article.
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"A paradox has emerged in the financial markets of the advanced economies since the 2008 global financial crisis. Unconventional monetary policies have created a massive overhang of liquidity. But a series of recent shocks suggests that macro liquidity has become linked with severe market illiquidity."
Policy interest rates are near zero (and sometimes below it) in most advanced economies, and the monetary base (money created by central banks in the form of cash and liquid commercial-bank reserves) has soared – doubling, tripling, and, in the United States, quadrupling relative to the pre-crisis period. This has kept short- and long-term interest rates low (and even negative in some cases, such as Europe and Japan), reduced the volatility of bond markets, and lifted many asset prices (including equities, real estate, and fixed-income private- and public-sector bonds).
And yet investors have reason to be concerned. . . . . .
. . . . .So what accounts for the combination of macro liquidity and market illiquidity?
For starters, in equity markets, high-frequency traders (HFTs), who use algorithmic computer programs to follow market trends, account for a larger share of transactions. This creates, no surprise, herding behavior. Indeed, trading in the US nowadays is concentrated at the beginning and the last hour of the trading day, when HFTs are most active; for the rest of the day, markets are illiquid, with few transactions.
A second cause lies in the fact that fixed-income assets – such as government, corporate, and emerging-market bonds – are not traded in more liquid exchanges, as stocks are. Instead, they are traded mostly over the counter in illiquid markets.
Third, not only is fixed income more illiquid, but now most of these instruments – which have grown enormously in number, owing to the mushrooming issuance of private and public debts before and after the financial crisis – are held in open-ended funds that allow investors to exit overnight. Imagine a bank that invests in illiquid assets but allows depositors to redeem their cash overnight: if a run on these funds occurs, the need to sell the illiquid assets can push their price very low very fast, in what is effectively a fire sale.
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My added comments:
We are living in the most difficult market conditions to stay informed about I have seen in my lifetime. There are risks everywhere. The IMF and the BIS have issued warning after warning about the risks including this about liquidity concerns. To that we can add warnings about derivatives, asset bubbles, shadow banking, and sovereign debt burdens. On top of all these we have the ongoing threat of cyber attacks (US government just got hacked again exposing 4 million employees), solar flares, and other potential disruptions to the electronic system that the global financial system depends on every day.
Despite all this, we have avoided another major crisis so far. But what we can take from all this is that it is beyond foolish to have no personal backup financial resources in case any of these problems does trigger another crisis. I liken it to owning a home with no homeowners insurance on it. We are swimming in uncharted waters and I don't think anyone on earth really knows how all this is going to turn out.
We can't live in constant fear of something that may not happen. But it's equally foolish to make no backup plan of any kind in case something does go wrong. Here we have Nouriel Roubini clearly stating "imagine a bank that invests in illiquid assets but allows depositors to redeem their cash overnight: if a run on these funds occurs, the need to sell the illiquid assets can push their price very low very fast, in what is effectively a fire sale." Mr. Roubini is one of the most respected economic analysts in the world.
The problem with many of these risks is that we the public have absolutely no way to stay on top of the situation to be able to react if a sudden problem arises. The system is still too non transparent and interconnected globally. Today, a problem anywhere in the world can lead to a problem everywhere in the world very quickly. Jim Rickards describes this as this snowflake that triggers an avalanche. No one can know which snowflake triggers the event.
In this environment we really have no choice but to make every effort to stay informed and put together some kind of plan in case a crisis disrupts the system suddenly with no warning. We will do our best to follow things here, but in reality no one can possibly stay on top of all these issues constantly. This is why some pre-planning is a must in the world we live in today. The more people there are who have a plan, the better we can all withstand a crisis if we do get one some day.
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