There’s a liquidity crunch developing

Alasdair Macleod – 08 November 2013

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.

Published by


Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

One thought on “There’s a liquidity crunch developing”

  1. Pingback: The Küle Library

Leave a Reply

Your email address will not be published. Required fields are marked *