Receding liquidity keeps markets shaky

Receding liquidity keeps markets shaky
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First Published: Fri, Nov 02 2007. 11 47 PM IST
Updated: Fri, Nov 02 2007. 11 47 PM IST
On Thursday, US stock market investors took fright.
The S&P 500 index fell by 2.6%, the financial sector sub-index declined 4.6% and the Vix index of stock market volatility increased by 25%. Last week, the currency markets freaked out over a possible dollar rout. A few weeks before, widening credit spreads were in the headlines. And back in August, money markets enjoyed an unusual—and unwanted—spell in the limelight.
What’s going on?
US subprime mortgages can explain some of the damage. Estimates of the total damage have increased sharply over the last two months. The losses will weaken the capital strength of some financial institutions, while the uncertainty has already led investors in many markets to take a more cautious stance.
But bad mortgage loans were more a symptom than a disease. Lenders had more liquidity than they could easily use. So they became buyers of all mortgages, few questions asked.
That policy made financial sense as long as most asset prices were increasing. The borrowers might go bad, but the house price would keep the loans good.
This tide of liquidity rose for years. Increases in overnight interest rates in the US and eurozone did little to stem it. As the waters rose, almost all markets were elevated, from fine art to leveraged buyouts. Sometimes one was especially strong, sometimes another.
The liquidity tide started to recede early in 2007. The market for US subprime mortgage-backed securities was the first to get stuck in the sand. But it was quickly joined by the wreck of the dollar and a sea change in the non-bank financial sector.
It looks like the patterns of the good years are being reversed. Sometimes one market is especially weak, sometimes another. The symmetry extends to overnight interest rates. Interest rate cuts by the US central bank haven’t done much to keep asset prices up.
As yet, a few markets have been spared. Most notably, the oil price is still close to an all-time high. Others have suffered only modest reversals.
But if the ebbing tide of global liquidity does not reverse direction soon, most of the holdouts will have their time on the sand.
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First Published: Fri, Nov 02 2007. 11 47 PM IST