Wednesday, June 6, 2007

One of My Favorite Quotes - Liquidity is There Until It Isn't

This article from Bloomberg ties in well with my post below. Also there have been an increasing number of articles like these recently. I am not so sure anyone knows anything the rest of us don't, but they are saying that the risk in the credit markets is no longer balanced. When that happens there is increased risk exposure to random shocks.

Nine years ago a default by the Russian government on part of its debt caused financial markets around the world to seize up as investors rushed to shed risk. Today, Federal Reserve officials are concerned something similar may happen.

The anxiety isn't centered on Russia or any other particular country. It's that good times have been rolling for so long in markets everywhere that investors and institutions are behaving as if they have forgotten that there are always risks, that there's always something that can go wrong (my emphasis). The good times have been fueled by a flood of liquidity supplied from the huge pool of savings in China, some other Asian nations and oil exporting countries. Meanwhile, market volatility has largely disappeared in the wake of the successful efforts to tame global inflation.

That combination of liquidity, low inflation and low volatility has reduced interest rates around the globe and sent investors scurrying to find higher yields almost regardless of risk.

And on May 31, Terrence Checki, an executive vice president at the New York Fed who has spent years dealing with financial crises, especially in emerging market countries, warned at a conference in Athens, ``The recent long period of stability may contain the seeds of its own undoing.''

``Abundant global liquidity has been a powerful wind in the back of economic and policy progress and has brought substantial benefits,'' Checki said. ``In addition, as we all know, liquidity is ephemeral: it disappears at the most inconvenient times.'' (my emphasis)

Perhaps what worries Fed officials the most is that monetary policy can't do much to reduce the risks in this situation.

The liquidity hasn't been created by monetary policy decisions in the industrial world, and the Fed and its counterparts can't sop it up. And now some of the countries sporting foreign currency reserves totaling in the trillions of dollars are beginning to search for higher yields too.

In this largely benign investment climate, it's impossible to pinpoint what might go wrong -- what might trigger a sudden massive move to shed risk, such as occurred after the Russian default in August 1998. In that case, liquidity simply evaporated from markets everywhere, even in those for U.S. Treasury securities.

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