Over the past decade, the expression “liquidity trap” has frequently come into use in Western markets. Because central banks provided so much funding for the financial system through quantitative easing, it seemed that the glut was becoming ineffective.
But now investors would be wise to consider another concept: the “liquidity hole” – or, perhaps more accurately, potholes, writes Gillian Tett for the Financial Times.
Although the Federal Reserve did not raise interest rates at its last meeting, its chairman, Jay Powell, essentially promised that rate rises would begin in March. More importantly, the Fed also released a paper promising to shrink its balance sheet.
All of this means that investors could soon see something in the markets that most have barely seen in the past decade (except during the early pandemic shock): a shortage of buyers for some assets relative to supply.
“This mismatch will show up first in the bond market, but then spread to other assets,” says Greg Jensen, chief investment co-director at hedge fund Bridgewater. “It’s going to be painful for many investors as they extrapolate into their portfolios the liquidity glut of the last decade” – and are thus unprepared for “holes.”
How painful will this be? An optimist might say that any price shocks will be modest. After all, by historical standards, the international financial system in general – and the U.S. system in particular – is awash in money.
That’s in part because the Fed doubled the size of its balance sheet to $9 trillion during the pandemic, after expanding it four times in the previous decade. Its counterparts in Japan, Europe and the United Kingdom were also hyperactive.
Meanwhile, private sector credit creation was also hyperactive – causing the closely watched Goldman Sachs Financial Easing Index to hit a record low of 97.73 at the end of 2021. This meant that funding was extremely plentiful.
Moreover, the numbers in the Fed’s tightening plans for 2022 don’t look massive compared to its balance sheet. The Fed expects to purchase $20 billion of U.S. Treasuries and $15 billion of mortgage bonds in February.