With all the news we wanted to discuss why the actions of Steven Mnuchin and the U.S. Treasury regarding liquidity are so important right now.
What liquidity means in investment speak is simply how easy money is to access. More liquidity means that it is easier access to an asset’s value, less liquidity means it’s harder to access. Addressing liquidity in the market has been one of the government’s biggest concerns and the measures they’re taking are extremely important to keep the financial markets functioning.
What does liquidity mean when put in context of financial markets?
Say a fund has some investors pull money and they need to sell securities to come up with that money. They have to find a buyer for whatever they’re looking to sell, and they HAVE to sell, they don’t have an option there. So, with fewer buyers what can happen is that fund will have to keep lowering the sale price of whatever it’s selling until someone bites. Once that price is set for that asset by that sale, you get what is called a marked-to-market movement on other securities like it. So, one bad trade can set new lows for pricing on whole groups of assets and we’ve seen this happen across the bond market.
The problem right now is, with no one really putting new money into the market, the buyers are few and far between. And even for a good manager to scoop something up, they may have to sell another asset which can be hard for them to do to even make the trade.
With everyone selling and no buying, we’re seeing values on all these securities drop simply because of this pressure on funds to come up with cash. This is what Mr. Mnuchin is stepping in to try to fix.
Before 2008, banks used to be the primary liquidity providers to the bond market, but after getting their hand caught in the cookie jar, they now have strict regulations on what they can own and how much. So, two weeks ago the FED announced an unlimited value of debt that they are willing to buy. This provides those funds with the buyer they so desperately needed and hopefully keep asset prices from being driven down to unreasonable levels. Investment products will be able to do their thing now and some semblance of reasonable asset pricing can resume.
The real values of many bonds out there will be rediscovered in coming months once people stop dumping their whole bucket and actually look at what’s in it. In the meantime, many bonds that will prove to be perfectly fine to own are sitting at historically low prices.