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Bill Gross: 6 Catalysts That Could Freeze Market Liquidity
Aspire, Thought Leaders | 08 July 2015
By: Lim Si Jie
Articles (169) Profile

Regulators, investment managers and analysts on the street are all speculating best possible indications that could signal the end of the six-year bull run. One of the current debates on the street revolves around the absence of liquidity and the negative effect it might have on future market prices of equities and fixed income assets.

Bill Gross also believes that illiquid assets are the most dangerous threat to the current market. Illiquid assets refer to the assets that involve high risks because of its inability to sell without making a substantial loss. He talks about six potential catalysts that would exacerbate this situation.

Huge Liquidity Problem

Fixed income assets such as bonds have been considered the safest and most liquid of investments, at least most of the time. However, in the current financial landscape, the threat of an illiquid market is very real. The liquidity implosion in 2008/09 forced levered investors to de-lever in a way.

Following that, several money market funds experienced a significant drop in value. This in turn threatened the $4 trillion overnight repo market, which is also the core of the world’s current finance-based economy.

In order to inject more liquidity into the market, the Fed and other central banks imposed emergency liquidity provisions of their own. This created an artificial demand for investments, which increased the liquidity of investments.

However, the recent congressional legislation to protect the “too big to fail” corporations that are supposedly the pillars of the US economy had been put in place. Furthermore, the Federal court rulings regarding the expropriation of American International Group’s (AIG) expropriation of shareholders’ capital was in the latter’s favour.

These cast doubts about global central banks and governments’ ability to use similar methods to stabilise future asset prices.

Dodd Frank Legislation & “Shadow Banks”

In order to prevent the same situation of an illiquid market, legislators introduced the Dodd Frank legislation. It constitutes stiffer regulatory mandates such as tightening bank capital standards, curtailing the size of the potentially volatile repo market from $4 to $2 trillion, and pursuing inquiries as to which financial institutions are “strategically important”.

However, Bill Gross believes that the Dodd Frank legislation’s effect is limited. According to Bill Gross, while the Dodd Frank legislation has made financial institutions less risky, their risks have really just been “transferred to somewhere else in the system”.

Unlike the financial crisis where Wall Street’s largest investment banks came under duress when liquidity dried up, Bill Gross postulate that the next wave will involve non-banking financial institutions like Pimco, which he terms as “shadow banks”.

Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down. When liquidity is scarce, prices tend to be bearish. This could trigger a domino effect on the global financial system.

Six Catalysts That Could Freeze Liquidity

Bill Gross warns market participants to pay special attention to six possible catalysts that could lead to a freeze in market liquidity and trigger the domino effect on the global financial system.

1) A central bank mistake leading to lower bond prices and a stronger dollar.

2) Greece’s inevitable aftermath of default/restructuring leading to additional concerns for Eurozone peripherals.

3) China’s credit has expanded more rapidly in recent years than any major economy in history. It is a warning sign of possible credit risks in the global financial system. Given that China’s financial system lacks transparency, there might be much more hidden problems than we see on the surface.

4) Emerging markets are also potential sources of a bond crisis with problems ranging from dollar denominated debt to overinvestment, and even over-reliance on commodity output.

5) Geopolitical risks, which are too numerous to mention and too sensitive for publication.

6) In a levered financial system, small changes can upset the status quo. The butterfly’s wing-chaos theory suggests that a small change in “non-linear systems” could result in large changes elsewhere.

Si Jie is no stranger to investing having started his journey at a young age. He is heavily influenced by acclaimed investors such as Benjamin Graham, Peter Lynch, and John Rothchild.

Please click here for more information about this author.


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