Wednesday, August 08, 2007

Market liquidity and money liquidity

We talked on Monday about the current level of liquidity in the markets. Today we will take a look at the difference between market liquidity and liquidity in the form of available money and credit.

When we talk about market liquidity, we generally refer to the ease with which assets and investments can be sold for cash. How liquid is the market for "x" - when we ask this question we are basically talking about how quickly we can turn item "x" (be it real estate, stocks, or bonds) into cash.

If we can readily exchange our investment for money and suffer no significant downward price movement in the process, then the asset or investment is liquid. If the market for an asset or investment is shallow, or inactive, with high bid/ask spreads and volatility, that market is said to be illiquid.

Illiquid assets and investments are often hard to sell, and oftentimes their sale can have a significant effect on prices in the market. This is one of the main issues in the ongoing credit-market panic. Fear has produced a surplus of sellers and a shortage of buyers for subprime backed CDOs and other exotic instruments.

Illiquid investments, such as CDOs and asset-backed securities, were widely held by hedge funds, banks, and investment funds. Now that their value has been called into question, panic has spread to much of the credit markets, affecting prices for junk bonds and other forms of corporate debt. This, in turn, has affected the LBO/private-equity deal market. As appetite for debt dried up, "deals galore" became "deals no more".

Recently, that fear spread to the equity markets, triggering a $2.65 trillion sell-off in equities worldwide. Although stock markets have been rebounding a bit in recent days, cheering themselves with visions of continued global growth and the Fed's assurances that the subprime fallout will not wreak havoc on the U.S. economy, one has to wonder what the future holds in store.

With that in mind, let us examine the effects that an expanding global money supply have had on the financial markets in recent years, as well as the likely future effects that any tightening (or further easing) of money and bank credit will have on investment markets.

Jeremy Grantham spoke earlier in the year of a "truly global bubble", one which encompassed all manner of assets in a number of locales. This global bubble was driven by the generous global supply of money and credit, the availability of which helped fuel widespread optimism and excessive risk-taking in financial markets.

Now we see that a reversal of the bubble's high-risk appetites and "animal spirits" is taking place, and so far it is very much in line with the script laid out by Mr. Grantham earlier in the spring. So does this spell the end for the "great bubble" of the early 21st century, or is it just a pause in the madness?

In order to get a better understanding of what will happen in the markets and the economy, we need to look at global money and credit conditions going forward.

Will liquidity, in the form of money and credit created by the banking system, increase or will it dry up? Will an abundant supply of money and credit continue to wash over the globe, taking asset prices higher, or will a money and credit contraction knock investment markets and asset prices down from their recent lofty heights?

In asking these questions, not only are we trying to divine the future of money conditions, we're also trying to find out what effect these conditions will have on our investments and on investment markets as a whole.

Is the relationship between money liquidity and investment/asset prices so straightforward? We'll try and examine that question in "Market liquidity and money liquidity, Part II". Stay tuned.