There’s a liquidity crunch developing

This week an article in Euromoney points out that liquidity in bond markets is drying up. The blame is laid at the door of regulations designed to increase banks’ capital relative to their balance sheets. Furthermore, the article informs us, new regulations restricting the gearing on repo transactions are likely to make things worse, not only reducing bond market liquidity further, but also affecting credit markets. The reason this will be so is that in a repurchase agreement a bank supplies credit to non-banks for the period of the repo.

One could take another equally valid point of view: the reason for deteriorating liquidity in bond markets is due in part to yields being unnaturally low. If you price bonds too highly, which amounts to the same thing, few investors want to buy them without the unconditional support of the central bank as a ready buyer. This, after all, is why just the hint of tapering recently was enough to derail the markets. So here again we come up against the same choice: if the Fed insists on mispricing the market with its interventions and zero interest rate policy it must fully support the market with both QE and also twist applied to the yield curve to maintain market liquidity.

For the investment analysts and commentators that still expect tapering this must come as something of a surprise. The underlying point they have missed is that once a central bank embarks on a policy of printing money as a cure-all, it is impossible to stop, or even to just taper without risking a liquidity crisis. Increasingly illiquid markets are now telling us that QE should be increased.

The point was rammed home this week by the ECB’s decision to lower interest rates. The move was sold to the financial press as designed to stimulate inflation and reduce the risk of deflation. However, central to the deflation argument is the need to stimulate liquidity in the secondary markets, which according to the Euromoney article “are now close to breakdown”.

At least the ECB rate cut should defuse tapering expectations in US markets, making it easier for the Fed to back down from its failed experiment. The Fed now needs to plant the suggestion that QE will have to be increased, or a similar mechanism designed to boost liquidity introduced.

This will not be difficult in the prevailing economic conditions. Even though GDP remains a positive figure, concerns over deflation abound and are preoccupying more and more analysts. These are concerns which analysts can readily accept as an immediate and greater risk than inflation.

This article was previously published at

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9 replies on “There’s a liquidity crunch developing”
  1. says: chuck martel

    ” However, central to the deflation argument is the need to stimulate liquidity in the secondary markets, which according to the Euromoney article “are now close to breakdown”.
    Why would Joe Lumberjack or Pete Coalminer care about a breakdown in the secondary market due to illiquidity? In the case of the US, the secondary markets look pretty good, since the stock indexes are at their highest levels ever. For the ordinary working stiff, wrapped in mortgages, car payments, insurance premiums, cell phone contracts and credit card debt, there’s no such thing as liquidity. An active participant in the consumer society’s passion for acquiring “stuff”, he can look at the Lexus parked in the driveway, financed for five years, and wonder how he’ll pay this month’s electric bill. Any concern about that however, is pushed into the future because we have to remedy the lack of liquidity that threatens secondary markets, which evidently means that if the financial industry doesn’t have enough money it won’t be able to inflate stock prices. That would result in freeway exits teeming with guys in suits and ties holding cardboard signs lettered with the words “No Liquidity, Please Help”.

  2. says: waramess

    I have great difficulty with the hocus pocus of monetarism. It’s not that I do not understand what they are saying; just that I don’t “get it”.

    You say “If you price bonds too highly, which amounts to the same thing, few investors want to buy them without the unconditional support of the central bank as a ready buyer.” Now that sounds to me a far more credible possibility. Who wants to be caught with a bunch of low yielding bonds when interest rates rise and everyone else is trying to sell? Sure way to bankruptcy.

    The ECB now dropped interest rates even further with a view presumably to increasing demand and thus maybe (retail) inflation. Well it didn’t work last time when interest rates were reduced dramatically so why should it do so this time?

    The fact is, like QE, the money is not getting through to the people responsible for increasing retail price inflation

    On the other hand Central Banks are fond of pointing out that printing all that money has had no effect on inflation. Do you think they might have missed the Facebook IPO? A company with no profits, no credible strategy for generating profits that would justify the pricing but people falling over themselves to buy.

    Maybe we should call it a bubble but I would call it inflation just as much as I would call the outrageous pricing in the stock market inflation and just as I would call the house prices in the UK, where in order for the average income to buy the average house a leverage of 5 times income is necessary PLUS a 25 percent deposit, inflation.

    Increasing the medium of exchange cannot possibly be the answer to increasing demand. It may be that it increases the Governments capacity to consume but that is done at a direct cost to the private sector first, and in that sense can only be deflationary.

    Maybe the best route to ending this recession is not to print and pray but to look at the reason why people stopped spending.

    Much of the spending came from good levels of employment resulting from the housing bubble and a good deal came from people raising second, third and fourth mortgages against their houses.

    The banks almost went bust and stopped lending against property, people who had previosly been able to spend considerably more than they earned stopped spending, new housebuilding almost ceased and employment that resulted from the housing boom dramatically reduced.

    The big mistake was to save the banks because the bad investments of the past remain which is preventing a recovery.

    Perhaps the answer is to raise interest rates and, this time, we don’t save the banks. Devestation certainly but the alternative is perhaps chronic deflation.

      1. says: George Thompson

        Facebook’s IPO price was set at $38.00 on May 18, 2012. That day it closed at $38.23. It closed November 15, 2013, at $49.01 for an ROI of 28.974% starting with its initial price.

        Twitter’s IPO price was set at $26.00 on November 7, 2013. That day it closed at $38.23. It closed November 15, 2013, at $43.98 for an ROI of 69.154% starting with its initial price.

        I recall sitting in the faculty lunch room during the heady days of the boom and listening to tablesfull of mathematical illiterates bragging about their ‘portfolios’ and how the old rules of investing no longer applied. They knew less about investing than they did about calculating 2 + 2 with a calculator. All they knew was what their broker told them. Hope that broker told them to sell before their fans turned icky brown. Don’t know as I had moved on by then. When I ponder Twitter and Facebook, I get a strong sense of déjà ipo all over again and wish I could be an insider with stock options just once.

  3. says: Paul Marks

    On the debate about “monetarism” – i.e. the belief that the money supply should be increased in order to maintain a “stable price level” (on some index or other)…….

    Frank Fetter refuted this Irving Fisher nonsense when Milton Friedman was still in short pants. And the crash of 1921 (and then 1929) refuted it in practice.

    As for the European Union Central Bank (the ECB) and their most recent antics.

    Some people have been claiming that the “Euro” is somehow special – and is not falling into the same credit bubble pit as the “Dollar” and the “Pound” (and so on).

    The recent cut in the ECB interest rate to (basically) zero, shows how foolish this faith in the Euro was.

    Sorry people – stick to gold and/or silver (the fiat currencies are all going to fall apart).

  4. says: James

    That’s as may be Paul, but the countries/regions with significant gold reserves will still be in a better position than those with low-to-non existant reserves (such as the UK). And it’s indisputable that the eurozone has significant gold, and that monetary officials there – in contrast to Britain and America – recognise the significance of this. See Draghi’s comments on gold the other day.

  5. says: Paul Marks

    James – I hope those European governments do not physically store their gold in the New York Fed. If they do – they may find they have rather less gold than they think they have.

  6. Alasdair isn’t quite correct to say “..once a central bank embarks on a policy of printing money as a cure-all, it is impossible to stop..”. It would be more accurate to say that if a country refuses to implement enough fiscal stimulus, and relies instead on monetary stimulus, then it will have problems withdrawing that monetary stimulus.

    And in the US, they have a serious phobia about more fiscal stimulus: that’s what the debt ceiling debacle was all about. George Osborne suffers from the same ailment, but in milder form.

  7. says: Paul Marks

    By “fiscal stimulus” Ralph Musgrave is pointing to the absurd fallacy that it is good for economic life for the government to borrow money and spend it.

    This deficit spending is bad – not good.

    However, I know from experience that Mr Musgrave will ignore economic law (as he always does), so let us have an “empirical test” – after all Mr Musgrave rejects the a priori bases of economic law and demands “tests”

    The government of the United Kingdom has one of the largest fiscal deficits in the world – it is borrowing and spending vast sums of money (even as a percentage of GDP). Mr Musgrave implies this is not the case (that the British government has a “phobia” about borrowing money) – Mr Musgrave speaks (as always) with forked tongue, as it is easy to check the truth (that the fiscal deficit in the United Kingdom is in fact huge).

    The government of the United Kingdom is also following an ultra loose monetary policy – of near zero interest rates and active Bank of England interventionism (Americans please note – the Bank of England is 100% government owned and has been since 1946).

    If Mr Musgrave is correct then Britain will prosper in 2014 and 2015.

    I say things will go badly – very badly indeed.

    Let us see which of us is correct.

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