Many market pundits will talk about a liquidity crisis, but they are not precise about what they mean by the term. A liquidity crisis can be broken into three different areas of focus in response to a negative economic shock. These liquidity shock alternatives will vary in strength and may resolve differently over time. This liquidity crisis breakdown may help with any discussion concerning current and future policy responses.
A liquidity crisis will start with a negative economic shock and may follow three different liquidity shock channels: a pricing effect, an economic accounting effect, and a leverage effect.
The pricing effect occurs when the negative economic shock impacts beliefs on pricing. If there is a strong common negative shock and expectations, there will be strong selling which can cause excess pressure to get out of markets at prices below fair value. With this forced selling buyers can only be found through giving them extra return for immediacy. This fall in price relative to fair value will be coupled with wider bid-ask spreads because dealers don't have the capital or risk appetite to warehouse assets. We have seen the impact of this pricing or market liquidity crisis in March especially with short-end rate spreads and off-the-run Treasuries. The Fed and other central banks through serving as the buyers of last resort and as providers of funds for financing reversed some of the extreme distortions seen in what used to be considered the most liquid markets.
The second focus of a liquidity shock or crisis is with the economics of the firm. Some will call this accounting liquidity. A slowdown in sales from sheltering in placing and business closings will mean a lack of firm cash flow liquidity to meet ongoing business obligations such as rent, payroll, and accounts payable. If cash is exhausted, the business and household cost is high without any relief. This is being solved with fiscal policy. The question is whether it will be fast or large enough to offset any economic gridlock.
The third liquidity shock focuses on the core function of capital markets and banking. Tighter liquidity conditions mean the cost of borrowing will increase. A negative shock will also see an increased demand for margin and collateral as the value of existing collateral is called into question. Tighter banking feeds back on the economic or accounting liquidity shocks while the higher margin requirements will impact pricing liquidity. This shock is where the Fed will step in with lending programs and changes in bank regulation.
We may be through the worst effects of the pricing gridlock. The lending and leverage effects are being worked through albeit far from solved. However, the economic effects on households and businesses may have the longest lasting and greatest negative effects. Stressed business and households cannot be snapped back like a rubber band. This is also where the impact of policy is most uncertain.
When discussing this liquidity crisis, break the discussion into these three areas of core stress.
The second focus of a liquidity shock or crisis is with the economics of the firm. Some will call this accounting liquidity. A slowdown in sales from sheltering in placing and business closings will mean a lack of firm cash flow liquidity to meet ongoing business obligations such as rent, payroll, and accounts payable. If cash is exhausted, the business and household cost is high without any relief. This is being solved with fiscal policy. The question is whether it will be fast or large enough to offset any economic gridlock.
The third liquidity shock focuses on the core function of capital markets and banking. Tighter liquidity conditions mean the cost of borrowing will increase. A negative shock will also see an increased demand for margin and collateral as the value of existing collateral is called into question. Tighter banking feeds back on the economic or accounting liquidity shocks while the higher margin requirements will impact pricing liquidity. This shock is where the Fed will step in with lending programs and changes in bank regulation.
We may be through the worst effects of the pricing gridlock. The lending and leverage effects are being worked through albeit far from solved. However, the economic effects on households and businesses may have the longest lasting and greatest negative effects. Stressed business and households cannot be snapped back like a rubber band. This is also where the impact of policy is most uncertain.
When discussing this liquidity crisis, break the discussion into these three areas of core stress.
No comments:
Post a Comment