Macro liquidity and market illiquidity - the problem

Nouriel Roubini, Dr Doom, nicely described the current market paradox of macro liquidity and market illiquidity as the big problem facing investors. His negativity may prove to be correct. This is a very important and subtle problem facing investors which is a collision between Minsky speculative behavior and a cascade problems. The Minksy description of bank lending behavior has been used to effectively explain the financial crisis. In very simple terms, a low risk stable rate environment breeds speculative behavior and risk-taking through leverage. The excessive speculative behavior of lenders creates the seeds for an unstable market environment. A cascade or herding problem exists when expectations or behavior is one-sided. Similar behavior or reaction to information will lead to a market cascade and extreme market moves. 

The current market environment of excessive central bank liquidity through QE has created an environment that has generated demand for leverage and risk-taking to offset low nominal yields. The environment is susceptible to cascades given the current one-sided environment. First, interest rates at the lower bound have a hard time going any lower. Second, with the current end of the QE, policy is biased in the opposite direction. It is just a matter of when; consequently, there is a one-sided bet that is waiting to determine when to reverse. With QE done, it seems a little late to the party to take new speculative positions. Hence, there will a bias for exiting position upon Fed signal of rate action. There will be no liquidity on the other side of trades if the market believes rates will start to move higher 

Additionally, while the Fed has added market liquidity, regulation has then away trading liquidity by reducing the speculative behavior of bank dealers. Excessive liquidity, one sided bets and views, and limited market-making capital provide an excellent environment for sharp market declines.