As the Fed tightens its belt and rates rise, investors from all corners of the market — retail, institutional, fund, and private — are worried about the potentially damaging effects of a looming liquidity squeeze. Whether you work in private lending, asset and investment management, or you even dabble in equities and mutual fund investing, a departure from assets to cash is something you simply do not want to see. Therefore, it is imperative that you understand how to spot the signs of an incoming liquidity squeeze, and ways you can protect yourself from the negative effects of such an event.
When lenders are faced with more requests for loans than they are able to give, it is called a liquidity squeeze; in other words, when demand outweighs supply. This can occur when the economy is growing quickly and demand for loans is high, or when lenders are worried about defaults and become more conservative. A liquidity squeeze can lead to higher interest rates and make it difficult for businesses and consumers to get the loans they need.
A liquidity squeeze happens after a financial event occurs that leads lenders, banks, investors, and other financial actors to believe the short-term availability of money may become limited. The financial events leading to a liquidity squeeze are varied. For example, the financial crisis of 2007-2008 was one such event, as markets went into freefall as a result of the collapse of mortgage-backed CDOs.
The financial contagion spread to markets globally, ushering in the dark days of the Great Recession.
Another example of a liquidity squeeze is the LTCM crisis in 1998, where hedge fund Long-Term Capital Management L.P. required a large-scale bailout due to high leverage and exposure to the 1997 Asian financial crisis and the 1998 Russian financial crisis.
There are increasing signs that a liquidity squeeze is coming in global markets. The first signs of a liquidity squeeze are usually a rise in short-term interest rates, and a fall in asset prices. We’ve seen both in the last few months, as stocks, crypto, and other easy money driven assets come crashing down to Earth. In addition, the Fed is pulling back, bond yields are rising, the dollar is strong, emerging markets are under pressure, commodity prices are falling, inflation is rising, and we’re seeing a general tightening of financial conditions across sectors. All of these factors combined present a strong argument for the potential of a liquidity crisis in the near future.
When a liquidity squeeze happens, it can be difficult for lenders to access the capital they need to continue operating. This can lead to a decrease in lending and an increase in the cost of borrowing, which in turn reduces the availability of credit and also increases its cost. These consequences compound the almost certain market volatility that will accompany the squeeze.
Planning and foresight are your biggest assets when it comes to protecting your portfolio from the destructive effects of a liquidity squeeze. Lenders may be able to defray some of the sting through the careful use of loan portfolio protection solutions like AXY Wrap®, helping them enhance liquidity while most of the market just tries to stay afloat. See how AXY Wrap® can help shelter you during the next global liquidity crisis.
This article does not constitute an offer to sell, or the solicitation of an offer to buy, any security interest in any jurisdiction. This material is distributed for informational purposes only and should not be construed as investment, legal, tax, regulatory, financial, or other advice. No assurance can be given that any investment objective will be achieved, or that an investor will avoid losses or obtain a return on an investment. While the information contained in this article is believed to be reliable, its accuracy is not guaranteed. Individuals should consult with their own professional advisors with respect to the legal, tax, regulatory, financial, and accounting consequences of any potential investment.