A Mirage, Not An Oasis: Easy Money and Financial Markets

IMF Blog, October 15, 2014

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Authors: Fabio Cortes, David Jones, Evan Papageorgiou
Date: October 15, 2014
Core message: Low interest rates and other U.S. central bank policies have driven investors into mutual funds and exchange-traded funds (ETFs), creating an illusion of liquidity and a buildup of liquidity mismatches and credit mispricing risks.

Mutual funds and exchange-traded funds are the largest owners of U.S. corporate and foreign bonds, effectively channeling investor funds into corporate credit.
Liquidity mismatch: investors can redeem fund shares almost anytime, while funds hold assets (for example, high-yield bonds) that do not trade as frequently.
In benign conditions this mismatch is manageable; if the U.S. Fed begins raising interest rates—especially unexpectedly—large simultaneous redemptions could:
- Trigger asset price declines.
- Cause further selling and a vicious circle of losses and forced selling.
- Complicate a smooth exit from accommodative monetary policy and increase volatility in fixed income markets.
Financial markets have shown increased sensitivity to price shocks since the crisis, particularly for credit products, increasing the risk of rapid selloffs.

Inflow liquidity (capacity to trade assets cheaply due to money inflows) has increased, while structural measures of liquidity such as depth and breadth have deteriorated.
Concentration risks:
- A few fund managers hold large amounts of assets, creating “brand risk” from concentrated decision making.
- Increasing concentration of holdings in individual bond issuers.
Reduced bank-provided liquidity: banks—traditional shock absorbers—are providing less liquidity.
Hedge funds are more sensitive to asset price changes.
Institutional investors are playing less of a countercyclical role.

Scenario: An unexpected market adjustment that causes:
- Term premia in bond markets to revert to historic norms (a 100 basis points increase), and
- Credit risk premia to normalize (a repricing of 100 basis points).
Impact estimate:
- Such an adjustment could rapidly push up bond yields and reduce the market value of global bond portfolios by over 8 percent — that is, $3.8 trillion.

Officials should address liquidity mismatches using prudential measures.
Example policy action: Remove incentives for runs by aligning redemption terms of funds with the underlying liquidity of the assets invested (i.e., match fund redemption features to asset liquidity).

Source: A Mirage, Not An Oasis: Easy Money and Financial Markets — Fabio Cortes, David Jones, Evan Papageorgiou, October 15, 2014.