Liquidity is the lifeblood of financial markets. It measures how easy it is for investors to quickly sell stocks and bonds. When investors get fearful but can’t sell their stocks, it causes even more panic. Nouriel Roubini, who has been dubbed “Dr. Doom” for his dark predictions, has joined a growing number of observers who warn that a “liquidity time bomb” could eventually “trigger a bust and a collapse.”
The above comments, and those below, have been edited for the sake of clarity and brevity to provide a fast and easy read and have been excerpted from an article* in money.cnn.com’s Investing Guide which was entitled Dr. Doom: This ‘time bomb’ will trigger next financial collapse and which can be read in its unabridged format HERE.
Several scary episodes back up his case that investors should be worried about “severe market illiquidity,” such as:
- the May 2010 flash crash, which sent the Dow Industrials plummeting nearly 1,000 points in about half an hour before recovering,
- the “taper tantrum” in the spring of 2013 when bond yields skyrocketed for a few days after ex-Fed chief Ben Bernanke suggested ending quantitative easing and the
- “flash crash” last fall when bonds mysteriously plummeting in dramatic fashion on one day before rebounding.
What’s causing these liquidity troubles? Roubini pointed to three major factors:
1) Herding behavior: Lightning fast trading makes up an increasingly large amount of activity in the stock market. This has led to “herding behavior” and crowded trades (think: bullish on the U.S. dollar) that can create chaos when surprises occur and everyone heads for the exits at the same time.
2) Bonds are not stocks: It’s important to remember that fixed-income assets don’t trade in super liquid stock markets. They mostly change hands in illiquid, over-the-counter markets. Despite that, as Roubini points out, investors can cash out overnight. That creates the potential for fire sales like those that hit the mortgage bond market in 2007 and 2008.
3) Banks are M.I.A.: During times of stress, investment banks used to act as stabilizing market makers in the bond market yet today’s banks don’t provide that safety net because post-crisis regulation has forced them to be smaller players in the bond markets.
Ironically, the concerns about liquidity in financial markets come after the Federal Reserve and other central banks created massive amounts of liquidity in response to the 2008 financial crisis. These emergency actions have helped keep bond markets relatively calm and lifted risky assets like stocks and real estate around the world, including in the U.S. yet Roubini and others fear this so-called “money printing” has also raised the risk of asset bubbles in various markets, including China, startups, tech stocks, bonds and luxury real estate. All of these investors have poured into these markets, but will they be able to get out?
Roubini believes we will see more than flash crashes, especially as asset bubbles continue to inflate, saying: “As more investors pile into overvalued, increasingly illiquid assets — such as bonds — the risk of a long-term crash increases,” he wrote. “Market illiquidity will eventually trigger a bust and collapse.“