the IMF said market liquidity, or the ease with which investors can quickly buy or sell securities without shifting their price, was “prone to sudden evaporation”, particularly in bond markets, when the Federal Reserve started to raise interest rates.
It said a steady growth environment and “extraordinarily accommodative monetary policies” around the world had helped to maintain a “high level” of liquidity. However, it warned that this was not the same as “resilient” liquidity that could support markets in time of stress.
How can this fragility have arisen?
Of course QE has not added to global liquidity as it has been an asset swap. Those assets were swapped for reserves however and some spilled over as excess reserves and in liquid form – they were more liquid in the hierarchy of money. In the absence of explicit fiscal expansion companies needed to leverage this relatively narrow liquidity expansion to assuage their need to acquire safe assets. This leverage is a function of principal and collateral. By spending excess reserves on commodities, often in emerging markets and puffed up by Chinese demand, they were able to leverage lending to purchase bonds – ‘safe assets’. Hence a narrow expansion of liquidity is expanded many fold through complex collateral chains on bank lending. The most notorious examples being the rolls of copper in Qindao port used many times to back loans. Hence the failure to expand properly the money supply after the financial crisis stole the potential for the next one.
Margin calls are now forcing commodity traders to liquidate commodities, which will send the prices down and reduce the value of collateral. Many companies may be technically insolvent in ‘mark to market’ terms. If lenders panic it could trigger a balence sheet recession.