shutterstock_221259493Why Are The Markets Worried About Liquidity?

We’ve heard a lot of talk lately by players in the markets about a problem that could raise its ugly head in a real crisis. Jamie Dimon, CEO of JP Morgan Chase, and Larry Summers, former Treasury Secretary, have warned about markets running out of liquidity.  But what does that really mean?  How could it impact you, the currency investor?

We all know that the currency markets are the most liquid markets in the world. At least the mainstream currency markets are. Smaller currencies may experience more volatility due to liquidity issues but that’s not what I am talking about here. The people I’ve mentioned were talking about a lack of liquidity in the U.S. Treasury market, the most liquid bond market in the world.  So, what’s up?

Basically, liquidity means having the other side of the trade available when you want to buy or sell something, and having it at a reasonable price. What has happened in the treasury market is a direct result of stepped up regulatory action in the U.S. bond market.  Whether or not you agree with the actions of the Obama administration under the Dodd-Frank law, one thing is for sure.  There are less big banks with active bond trading desks in the market.  And, there are less bond market dealers and traders in the market in general.  This means, there are less people to contact to find the other side of the trade at a reasonable price.

Former Treasury Secretary Lawrence Summers and the CEO of JP Morgan Chase, Jamie Dimon, have been very vocal recently about reduced liquidity in the bond market.

“I thought regulatory authorities made a mistake when they looked at each institution, and said, ‘You’ll be safer if you withdraw from the markets a bit,’ and then forget that if all institutions withdraw from the markets a bit, the markets would be less liquid. The markets themselves would be less safe. That would, in the end, hurt all institutions,” Summers said.

“I think there is a real issue there. Frankly, a lot of the effort that’s going into macro prudential should be into making sure we have liquidity,” Summers said.

How does this affect a currency investor?  Two words—interest rates.  For instance, if a trader is looking to sell a bond and puts the offer into the market, he finds a buyer.  However, what if he can’t find a buyer at the price he is looking for?  Maybe the bond he is trying to sell doesn’t have as many trading desks willing to own a treasury at that price, so he has to lower his offer price.  Bond prices have an inverse relationship to interest rates.  So, if the price goes down, interest rates go up.

Now, what if we have a crisis in the ability of the U.S. government to pay back the money it has borrowed and therefore markets start demanding Uncle Sam pay them a higher interest rate for loaning them money. That means the prices of bonds go down.  Now lets assume that a whole bunch of people want to sell their lower yielding bonds.  But, there are not as many market makers so the price of a bond can get skewed up or down very quickly if most of the selling is one way.

That is what these people are talking about when they mention a liquidity crisis.

Again, how does that affect a currency investor.  Well, interest rates affect currency prices.  If rates in the U.S. go high quickly, which is what these people are talking about, then the level of of the dollar in the markets against other currencies would be affected.  Higher interest rates would cause higher demand for the dollar.  Of course if the underlying fundamentals of the dollar are questioned as well, this could negate this upward pressure.

However, as a currency investor, understanding what could happen in the markets is critical to making sound investment decision.

L.Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is also an author of historical fiction thriller novels. His first of several books, Currency, deals with the consequences of overwhelming sovereign debt.  He is a contributor to Fox Business,  Newsmax TV, and others.