How Does the Market Work? Real Findings from the BIS

How the market works has changed from a few decades ago. In today’s hyper-financialized and interconnected world, investors can't afford to solely focus on fundamentals.

Global liquidity – which moves on many factors that aren't considered fundamentals – has become an increasingly important factor that drives market movements.

A contraction in liquidity on a global scale will trigger redemptions and margin calls across the board and cause the decline of most risk assets (stocks, commodities, high-yielding currencies, etc.; assets positively correlated to economic growth or financial easing).

A global rise in liquidity – the pumping of more money into financial assets – will conversely cause risk assets to rise.

This dynamic applies to individual market as well; the withdrawal of liquidity often causes disaster while the rise of liquidity fuels big rallies.

For example, the securitization of mortgages, which made them more tradable (i.e. increased its liquidity), is a big factor that led to the excesses of the U.S. real estate market.

What made it finally pop was when French bank BNP Paribas decided to suspend three of its funds that held subprime mortgages, citing the “complete evaporation of liquidity in certain market segments.”

In light of these and other recent liquidity-related events in the global financial system, the Bank for International Settlements (BIS) examined the drivers of liquidity – in both the global sense and for individual markets. This exercise was done to enhance policymakers’ understanding of the subject.

However, because liquidity is such a dominant driver of market movements, the BIS’ findings, published on Nov. 13, are also highly useful for investors.

Below is a summary of the factors (in no particular order) – both fundamental and financially-oriented – that drive market liquidity.

Financial Regulation

The flow of liquidity often depends on whether or not certain investors are allowed to put money in certain financial assets.

For example, loosening rules that restrict pension portfolios or foreigners from owning stocks often sparks a boom in the stock market.

Financial regulation also applies in the sense that some countries have more stringent rules than others. The countries with more generous rules usually get more liquidity. However, they are also more prone to dangerous excesses (i.e. financial bubbles).

Financial Innovation

Financial innovation influences whether or not certain investors are able to (conveniently) put money in certain financial assets.

A great example of this factor at work is the gold market. Previously, it was a pain for retail investors to buy gold; they had to either store it physically or perpetually roll over futures contracts.

The invention of gold exchange-traded funds (ETF), however, made owning gold much easier for them. Gold ETFs consequently became a big factor that contributed to the gold boom.

The securitization of mortgages is another example that illustrates the powerful influence of financial innovation.

Domestic Short-term Interest Rates

Short-term interest rates are set by authorities. Lowering rates usually increases borrowing and therefore boosts liquidity. Raising interest rates usually does the opposite.

In boom and bust cycles of risk assets, booms are usually sparked by low interest rates and busts are almost always preceded by interest rates hikes.

Domestic Long-term interest rates

Long-term interest rates are influenced by authorities. They mostly reflect long-term inflation expectations. Occasionally, surging long-term interest rates spell doom and disaster (e.g. the surging Greek 30-year yield during the 2010 to 2011 European debt crisis).

Lower long-term interest rates generally lead to increased liquidity.

Monetary Policy Spillovers

Monetary policy often spill over. That is, loose monetary policy (i.e. low interest rates) in one country can increase liquidity in another country.

Perhaps the most well-known example of this is the U.S. Federal Reserve’s quantitative easing (i.e. money printing) from 2010 to 2011, which pumped liquidity to most of the world because the U.S. dollar is the global reserve currency.

Countries with a pegged or heavily-manipulated currency (like China) tend to feel the spillover effect the most because they effectively adopt the monetary policy of the currency they are pegged to.

Even for countries with free-floating currencies, the BIS report concluded that spillovers occur due to “strong international asset market linkages among advanced countries.”

Central Bank Liquidity Policies

Besides adjusting interest rates and quantitative easing, central banks can control liquidity through other policies.

One policy is special lending facilities. Another is changes in collateral rules.

These measures are mostly used in crisis situations and usually lessens the severity of the crisis.

Growth

Growth is perhaps the oldest and most well-known factor that drives liquidity and risk asset prices. It does so by tempting investors to move from cash to risk assets (in order to participate in the growth).

Negative growth, conversely, usually prompts investors to move from risk assets to cash, which could produce a vicious market decline in the process.

Risk Appetite

The BIS report defined risk appetite as the “willingness of market participants to provide liquidity,” which depends on “risk preferences and assessments.”

It focused on the “cyclical behavior” of risk appetite. That is, increasing risk appetite often leads to factors (like financial asset appreciation) that lead to even more risk appetite and liquidity.

The report is essentially referring to momentum.

In the absence of a reversal trigger, liquidity will usually lead to more liquidity. On the flip side, the contraction of liquidity will lead to more contraction until the majority of investors have moved to cash or until the market encounters a reversal trigger.