What is Liquidity?
In financial market terms, a liquidity crisis is defined as the ability to convert an asset into cash. This is also where the term comes, “to liquidate”.
Assets that turn to cash easily are said to be liquid. Liquid assets are securities like stocks, as they always have a secondary market available for trading.
Assets that cannot be turned into cash are called “illiquid”. An example is a real estate, it is very time consuming and the transaction costs are high to sell a home.
But what happens if you hold assets that do not convert to cash easily, and happen to need cash in the near term?
Liquidity Risk (Cash is King)
The concept of liquidity risk is fairly simple. It is defined as the risk that a company will go bankrupt because they cannot convert their assets into cash quick enough to sustain their liabilities.
Even though a business can have a massive book of assets, if they cannot pay their short term obligations – they will have to declare bankruptcy.
This is why in business, it is extremely important to manage your cash flow to prevent a liquidity risk event that turns into a full blown liquidity crisis.
But if money earns a small return, why is there such a big demand for liquidity?
Let’s take a deeper dive.
Liquidity Crisis and Stock Market Crashes
Imagine for a moment that a big company had big liquidity risk. That is, they are unable to make a short term loan payment because they do not have enough cash on hand.
Assuming you are the CEO of this company, what do you do next?
You pull up a list of your assets, and look to find the ones that are most liquid. This is because you want to sell them quickly (to convert to cash) while still getting a fair market price for them.
Now let’s imagine that a massive pandemic hits the market – like Coronavirus.
Consumers stop shopping overnight, and the entire economy grinds to a halt suddenly. Companies lose their income source (revenue). Meanwhile, the fixed expenses continue to roll in monthly. Creditors still need to get paid.
Eventually, a business will need to raise some cash by selling their assets to meet the liquidity needs before running into a full blown liquidity crisis.
But what happens if every company in the US needs cash at the exact same time?
You get the scenario of panic selling assets, oftentimes at a steep loss, in order to generate enough cash to prevent a bankruptcy.
This is the true meaning of Warren Buffet’s quote that “you want to be greedy when others are fearful”. The idea is to take advantage of the company’s desperation for cash.
If you’ve saved up, or have liquidity you can negotiate terms. You can make low offers for assets and buy them far below market price.
Hence, when the economy faces difficulty – stock markets and asset prices drop sharply. This is because everyone is selling them to “liquidate” their holdings and convert them to cash.
Cash, at the end of the day, is king.
Lender of Last Resort – Preventing Economic Collapse during Liquidity Crisis
When all of the businesses in the country need cash, it becomes a dire situation. This can easily lead to a massive depression that lasts decades.
During these tough times, the Federal Reserve (in the US) steps into the rescue.
What the Federal Reserve does is called “quantitative easing”. Said more simply, the Fed is printing money and lending it to banks and corporations.
The topic of quantitative easing is better saved for another article.
What you need to know is that as the Fed’s balance sheet grows in size, the money they have printed has also increased in direct proportion.
The chart below from the FederalReserve.org website depicts the real growth of the balance sheet.
What do you notice by looking at the chart?
The balance sheet grew the most in 2009 and 2020. In 2009, the stock market crashed as the housing bubble imploded. Asset prices got hammered as companies chased liquidity to avoid bankruptcy.
In 2020, the Coronavirus pandemic caused a massive economic collapse. The Federal Reserve took action and grew the balance sheet from $4 trillion USD to over $7 trillion (175%). This balance sheet growth means the Fed printed trillions of dollars to prevent a massive liquidity crisis.
In the next chart below, we compare the S&P 500 stock market (candle chart) with the Fed Balance sheet (orange line chart)
As you can see, the stock market is following the Fed’s every move. The stock market is in fact no longer responding or reacting to fundamentals and the economy – it is mirroring the Fed’s cash printing.
Notice that in Jan of 2018, the Fed started to reduce the liquidity – which caused a market meltdown in December.
Alternatively, as soon as the Fed started to print money and provide liquidity during the Coronavirus pandemic, the SP500 shot up like a rocket.
Conclusion: Liquidity is the Lifeblood of Markets
Liquidity risk can turn to a liquidity crisis, which is accompanied by massive stock market crashes.
This is the reason the Federal Reserve has provided stimulus (aid) in the form of quantitative easing since the last recession.
In fact, the market has constantly received infusions of fresh cash since the housing market collapsed.
The Fed has prevented a lot of economic carnage by printing money. But the question remains, will cash printing one day stop working?
And if it does, will we see a massive liquidity crisis which causes the end to the current financial system?
No one knows, and it doesn’t help to fight the Fed.
As traders and investors, all we can do is assess the real-time opportunities and make decisions based on the present.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.