Investors: beware liquidity holes

By Gillian Tett

In the past decade, the phrase “liquidity trap” has often been tossed around in western markets. For central banks have provided so much funding for the financial system, via quantitative easing, that it seems that the glut was becoming ineffective. This week, however, investors would be wise to ponder another concept: a “liquidity hole” — or, perhaps more accurately, holes….From a long-term perspective, this is a healthy development, given that a decade of ultra-loose policy has pumped asset prices to crazily high levels, relative to real economic growth. Indeed, I would argue that the Fed should have started tightening some time ago. But desirable or not, nobody should ignore how risky this shift is — and how hard it is to model the market implications. Nobody knows what will happens when a central bank tries to simultaneously raise rates and shrink its balance sheet, since it has never been done on this scale before. Nor do we know how tightening will play out in a world where so much credit intermediation is now moving through markets (not banks, as before) — and where wealth inequality, partly due to high asset prices, is potentially “blocking monetary policy transmission”, as Karen Petrou, a financier, argues. We are in uncharted territory. No wonder that Powell admitted this week that “I don’t think it is possible to say exactly how this [tightening] is going to go”. If anything, that is an understatement. Investors should take note and watch out for those liquidity holes.