The Liquidity Time Bomb: Roubini

- Nouriel Roubini, a professor at New York University, described the liquidity in the markets as "time bomb" and warned it would "eventually" trigger a bust and collapse, in his analysis published on Project Syndicate, on Monday.

"A paradox has emerged in the financial markets of the advanced economies since the 2008 global financial crisis. Unconventional monetary policies have created a massive overhang of liquidity. But a series of recent shocks suggests that macro liquidity has become linked with severe market illiquidity" Rubini, known also as "crisis oracle" has said.

Policy interest rates were near zero and sometimes even below it in most advanced economies, he stated, as the money created by central banks in the form of cash and liquid commercial-bank reserves had soared, doubling, tripling, and in the United States, quadrupling relative to the pre-crisis period.

"This has kept short- and long-term interest rates low - and even negative in some cases, such as Europe and Japan - reduced the volatility of bond markets, and lifted many asset prices, including equities, real estate, and fixed-income private - and public-sector bonds" he added.

In short, though central banks’ creation of macro liquidity might keep bond yields low and reduce volatility, while tighter regulation meant that market makers were missing in action, he said.

"As a result, when surprises occur – for example, the Fed signals an earlier-than-expected exit from zero interest rates, oil prices spike, or eurozone growth starts to pick up – the re-rating of stocks and especially bonds can be abrupt and dramatic: everyone caught in the same crowded trades needs to get out fast. Herding in the opposite direction occurs, but, because many investments are in illiquid funds and the traditional market makers who smoothed volatility are nowhere to be found, the sellers are forced into fire sales."

"This combination of macro liquidity and market illiquidity is a time bomb" he went on, stating that it has led only to volatile flash crashes and sudden changes in bond yields and stock prices, so far. "But, over time, the longer 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 increased, he warned. "This is the paradoxical result of the policy response to the financial crisis. Macro liquidity is feeding booms and bubbles; but market illiquidity will eventually trigger a bust and collapse."