The Liquidity Addiction
Liquidity is among the most important factors influencing market behavior today. Why is this so and where does liquidity come from?
Here comes the world
With the look in its eye
Future uncertain but certainly slight
If you're buying or selling shares of General Electric (GE), the difference between the buyer's bid price and the seller's ask price is typically only a penny or two, so you should be able to complete your transaction close to the market price. A narrow 'bid/ask spread' is one characteristic of a 'liquid' market. Liquidity is among the most important factors influencing market behavior today. Why is this so and where does liquidity come from?
Effective market participants are aware of the concept of liquidity and its effect on asset prices.
The notion of liquidity and its influence on asset prices pervades a significant portion of Minyanville content. For example, Minyanville professors periodically note that market prices appear to be 'liquidity driven' and that this liquidity is linked to activities of the Federal Reserve.
To understand what they are talking about we first need to define liquidity. There are various definitions of liquidity in the financial context. The Minneapolis Fed defines liquidity as:
A quality that makes an asset easily convertible into cash with relatively little loss of value in the conversion process. Sometimes used more broadly to encompass credit in hand and promises of credit to meet needs for cash.
The Congressional Budget Office adds that liquidity is:
The ease with which an asset can be sold for cash. An asset is highly liquid if it comes in standard units that are traded daily in large amounts by many buyers and sellers. Among the most liquid of assets are U.S. Treasury securities.
A 'liquid' market can be viewed as one where buyers and sellers can enter and exit at close to prevailing market prices. Markets are more liquid when there are a) large quantities of assets available for trading, and b) many buyers and sellers with the funds and desire to trade them. As noted in the CBO definition above, U.S. Treasury securities are among the most liquid of financial markets.
The Bid/Ask Spread
An example of a less liquid market is real estate. Homeowners know that when they decide to sell their house, it will probably take time and considerable negotiation before the sale is consummated. For example, a seller might list a house for $200,000. The property may be 'on the market' for some time before a prospective buyer emerges. Even then, the prospect often offers less than listed price. For example, the prospective buyer might bid $180,000 against the seller's $200,000 asking price. A negotiation process typically ensues during which a buyer and seller may or may not agree on a suitable selling price. The process continues, sometimes for long time periods and with many potential buyers, until a sale is realized.
In the above example, the difference between the buyer's and seller's price (often called the 'bid/ask spread') is considerable. In percentage terms, it is ($200,000-$180,000)/$200,000 = 10% of the asking price. The bid/ask spread is often a good way to judge market liquidity. Well known stocks with large market capitalizations such as General Electric usually trade at a bid/ask spread of a fraction of a percent. However, less popular or smaller market capitalization stocks may trade at bid/ask spreads of one percent or more.
A good rule of thumb: The wider the bid/ask spread, the less liquid the market.
The Fed's Liquid Tide
The Federal Reserve has often assumed a role of 'liquidity provider' for financial markets--particularly during times of market stress. During market panics, bid/ask spreads often widen as buyers are reluctant to buy. As such, liquidity in turbulent markets often 'dries up' and panicky sellers consequentially 'hit bidders' at much lower prices than usual.
During times of financial market stress, the Fed often intervenes by injecting money and credit into market systems. For example, in the turmoil that followed the 9/11 tragedy, the Fed pumped large amounts of money and credit into US financial systems to improve liquidity. The Federal Reserve influences market liquidity through various means, including direct security purchase (commonly referred to as 'open market operations'), manipulating short term lending rates to borrowers, and adjusting reserve requirements. The Fed has provided liquidity during many crisis situations, such as after the 1987 stock market crash, and after the Long Term Capital Management debacle in 1998.
As such, the Fed is often viewed as a 'lender of last resort' in times of financial crisis.
Issues with Central Bank Intervention
Many people view the Fed's 'lender of last resort' role as essential. However, some have argued that the costs of Fed intervention outweigh the benefits. Let's consider a couple of these arguments.
a) Liquidity encourages excessive speculation
Some believe that ever since the Federal Reserve's intervention following the 1987 stock market crash, the tendency for markets to speculate has been increasing. The Fed's tendency to intervene during periods of market stress, it is argued, creates a 'moral hazard.' Moral hazard is disposition to engage in risky behavior because of a tacit assumption that someone else will bear the costs if risk comes to fruition in the form of losses (Wolfe, 2002). Simply stated, people take more risk than prudent when they sense that someone will bail them out if the situation deteriorates.
Many argue that the benefits of added market functionality from the Fed's liquidity outweighs any moral hazard cost incurred. However, prior to the Federal Reserve's creation in 1913, markets were able to provide adequate liquidity on their own, and in a manner that led to less extreme peaks and valleys in the business cycle than those that have been observed since the Fed's founding (Rothbard, 1963). Less effective market decision-making may result.
Central bank intervention policy that bails out market participants during times of trouble may lead individuals to believe that they are insured against downside risk and to take more risk than they should (Miller, Weller & Zhang, 2002).
b) Effects of liquidity can't be controlled.
The Fed's primary method for providing liquidity is through various open market operations that increase the supply of money and credit. Increasing the supply of money and credit will cause an increase in prices (Mises, 1934). But increase in prices of what? While the Federal Reserve can facilitate money and credit creation, it can't control where the liquidity goes. Among other things, inflating money and credit supply could cause stock or bond prices to rise, increase prices of consumer goods, or it could put a bid under housing prices. Controlling the precise effect of adding money and credit to the financial system can be difficult (Mises, 1934).
Liquidity tends to follow the path of least resistance, and consequentially may manifest in the prices of asset categories far from those targeted by the interventionists (Anderson, 1949; Mises, 1934).
c) It's difficult to turn off the liquidity spigot.
From 2004 through 2006, the Federal Reserve engaged in a campaign to increase interest rates, with the discount rate and federal funds rate target rising from nearly 1% to 5.25% during this period. One would think that a 400% increase in general borrowing costs should remove considerable liquidity from the financial system. However, broad measures of money supply actually increased during this period!
Because increased money supply tends to serve bureaucratic agendas, it is possible that the Fed and other central banks lack the political will to stop liquifying financial systems. The danger is that financial systems, like drug users who depend on their next fix, can become addicted to liquidity. History suggests that once financial markets become dependent on liquidity injections, this dependency can be difficult to break without severe consequences (Anderson, 1949; Rothbard, 1963).
Prolonging the Inevitable?
The extent to which central bank liquification efforts have persisted without a negative market response has surprised some observers. Skeptics believe that it is only a matter of time before market participants no longer want to take risk with the liquidity offered by central banks. They claim that intervention by the Federal Reserve or any outside entity merely prolongs the inevitable cleansing effect, and may well exacerbate the cleansing when market forces ultimately assume control.
A liquid market is one where buyers and sellers can enter and exit at close to the prevailing market price. Generally speaking, the wider the bid/ask spread, the less liquid a market. Central banks such as the Federal Reserve have played a major role in 'liquefying' global financial markets. Arguments against central bank-induce liquification include an increase in moral hazard among market participants, lack of control over the effects of liquidity on the prices of asset categories, and an addiction to liquidity that can be difficult to quit.
Must the 'dark side' of liquidity injection come to fruition in financial markets? Perhaps not. But an intelligent market participant recognizes the power of liquidity and its potential consequences.
Anderson, B.M. (1949). Economics and the public welfare. New York: D. Van Nostrand Co.
Miller, M., Weller, P. & Zhang, L. (2002). Moral hazard and the US stock market: Analysing the 'Greenspan Put.' The Economic Journal, 112: 171-186.
Mises, L. (1934). The theory of money and credit. London: Jonathon Cape Ltd.
Rothbard, M.N. (1963). America's great depression. Princeton, N.J.: D. Van Nostrand Co.
Wolf, Jr., C. (2002). Straddling economics and politics: Cross cutting issues in Asia, the United States, and the global economy. Santa Monica, CA: RAND.
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