The global financial system is awash in liquidity, created by central banks as they have driven short-term interest rates to zero (or even below) and expanded their balance sheets by the equivalent of trillions of dollars. And so the world is swimming in cheap money.
At the same time, liquidity is said to be at a low ebb in the financial markets, especially for bonds. Even for the most gilt-edged securities of the strongest and biggest economies, which serve as the financial world’s benchmarks, U.S. Treasuries and German Bunds, liquidity appears to be lacking. As a result, transactions that once didn’t cause prices to budge now send them lurching from trade to trade.
This apparent paradox was deftly described by New York University Prof. Nouriel Roubini, aka this century’s Dr. Doom, in a piece published last week with a characteristically understated title, “The Liquidity Time Bomb.”
Even with billions in excess reserves sloshing around the banking systems in the U.S. and abroad, and paying zero—or having a negative interest rate imposed on banks for the privilege of stashing their cash with central banks in Europe—this lack of liquidity in the capital markets became starkly evident last week, as yields on Bunds and Treasuries surged. And the advice from central bankers on both sides of the Atlantic about this new volatility? Get used to it.
So what accounts for what Roubini describes as the odd combination of “macro liquidity and market illiquidity”? Among the factors he lists:
In the equity market, the increased prevalence of so-called high-frequency traders, driven by computer algorithms, results in “herding behavior.” Volume is concentrated at the open and close of the day, worsening liquidity during the rest of the session. (But given the continued low level of equity volatility as indicated by the VIX, the so-called options fear gauge, the impact of the algos remains an open question.)
It’s in the fixed-income arena where the illiquidity has grown and become more worrisome. Unlike equities or commodities, where myriad buyers and sellers trade standardized instruments on an exchange, fixed-income consists of highly heterogeneous securities. To buy a bespoke bond, somebody must sell it, which is where dealers come in. Historically, they would “make markets”—that is, buy and sell securities for their own account, presumably making a profit on both sides of those trades.

But in the postcrisis regulatory environment, banks’ market-making has been curtailed. New regulations and capital charges have induced them to shrink their securities inventories—which serve as the buffer between buyers and sellers. The result is greater volatility, as Roubini writes, a point on which virtually all fixed-income pros—whether institutions on the buy side or Wall Street banks on the sell side—agree.
The other aspect is the greater role played by intermediaries, such as bond mutual funds and especially exchange-traded funds. ETFs in particular offer the liquidity of listed stocks in an instrument consisting of varying liquidity, while open-end funds offer the functional equivalent of a bank deposit on illiquid assets.
A “run” on these funds forces them to redeem bonds, pushing down prices very fast and exacerbating swings in an already illiquid market. ( BlackRock[ticker: BLK] CEO Laurence Fink pushed back against this scenario in a chat with Barron’s editors last week, which was posted by our colleague Chris Dieterich on his Focus on Funds blog.)
“This combination of macro liquidity and market illiquidity is a time bomb,” Roubini contends. “So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer that central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into overvalued, increasingly illiquid assets—such as bonds—the risk of a long-term crash increases.”
And not long after the electronic ink had dried on his essay, Bunds went into a steep nose dive. The yield on the benchmark 10-year maturity nearly doubled from the level a week earlier, almost reaching 1% (remember the yield was a hair above zero just a few weeks ago). A half-point rise in the 10-year German bond yield doesn’t sound like much to equity-oriented investors, but in price terms it’s analogous to an 800-plus-point plunge in the Dow industrials.
Concerned about more financial market upheavals, International Monetary Fund Managing Director Christine Lagarde last week urged Federal Reserve Chair Janet Yellen to defer the U.S. central bank’s initial hike in the federal-funds rate, which has been near zero since December 2008 at the depth of the financial crisis, until 2016.
The Fed should take into account global financial conditions in its decisions, Lagarde contended.

While the Fed’s remit is to promote high employment and low inflation in the U.S., the impact of decisions by the central bank overseeing the world’s biggest economy and financial markets extends far beyond its borders.
In a speech on Friday, New York Fed President William Dudley also said that the central bank should take financial market conditions into consideration. But he reiterated Yellen’s recent point that the initial liftoff in rates is likely to take place this year.
If a Fed hike results in a sharp rise in long-term interest rates—as in 1994-95—the monetary authorities would be apt to go slower, Dudley said. (That episode of sharp rate hikes roiled the mortgage-backed securities market, leading to the bankruptcy of Orange County, Calif., which had speculated in derivatives, and helped precipitate Mexico’s “tequila crisis,” which resulted in a big peso devaluation.) In contrast, if financial conditions and long-term interest rates fail to respond to Fed tightening—as in 2004-2007, which resulted in the housing bubble and subsequent financial crisis—the central bank would likely hike rates more quickly.
As president of the New York Fed, with offices just a few blocks from Wall Street, Dudley is at the nexus of monetary policy and the financial markets. And as the former chief U.S. economist at Goldman Sachs, he also just might have more than an academic knowledge of how markets work.
But more important than when the Fed starts hiking is how the increases progress. And how markets act and react to rate hikes will be important determinants of this. That said, Dudley added, “My own view is that there likely will be some turbulence.”
Similarly, European Central Bank President Mario Draghi flatly said that markets should “get used” to the sort of volatility that roiled the European bond markets and washed up on U.S. shores last week.
In essence, central bankers want to minimize the ructions in the markets from their policies. As I wrote in the weekday edition of this column last week, former Fed Governor Jeremy Stein contends that it would be better if the central bank practiced tough love and cared less about the market’s feelings. That’s not the parenting approach being taken by Dudley and his colleagues, however.
All of which attempts to resolve Roubini’s paradox of illiquid, volatile markets, amid the flood of liquidity created by central banks. Whether monetary authorities can actually pull it off is far from certain.
AGAINST THAT BACKDROP, the benchmark 10-year Treasury yield last week jumped 30.5 basis points (0.305 of a percentage point), to 2.402%, the highest since last October, with a lift on Friday from stronger-than-expected May employment data. The numbers released that morning showed a 280,000 gain in nonfarm payrolls, well over the 226,000 that had been forecast, and a 0.3% rise in average hourly earnings. Even the 0.1 percentage-point uptick in the headline unemployment rate, to 5.5%, was good news, as it represented a rise in the number of folks getting out of bed in the morning to enter the labor force.
Still, the Dow posted its third losing week in a row, falling more than 2% over that span. That’s a show of relative resiliency in the face of rising bond yields. And that’s typical of patterns when higher interest rates are seen as reflecting a stronger economy.
One such benign episode came in 1987—until it wasn’t, as Steve Blitz, the chief economist of ITG, recalls in a research note. Initially that summer, the stock market continued to head blithely higher, with subdued volatility. But when bond yields started shooting too high as the fall approached, then–Treasury Secretary James A. Baker III said he’d prefer the dollar to fall than to have rates rise further. The 30-year long bond’s yield topped 10%—offering too much competition for a stock market trading at a 20-plus price/earnings ratio.
Viewing the global backup in Bunds, Blitz notes that cross-border capital flows now are driving interest rates, as they did in 1987. He doesn’t expect anything like that year’s bond rout and stock crash. But he concludes that, when long-term rates rise for reasons other than a demand for capital for fundamental corporate reasons, “the yield rise will eventually put an end to an equity market rally.”
The Fed wants to lean against this possibility. Again, the question is whether it can, or at what cost.