How Does a Liquidity Trap Affect Investors?

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A liquidity trap is what the European Central Bank (ECB) wants to avoid. The ECB chief recently stated that although they were cutting rates to 2% they did not want to find themselves in a liquidity trap. That has lead many investors and analysts to assume that there won’t be another cut for another two meetings. This should be prompting investors to ask what a liquidity trap is and how it could affect them.

[VIDEO] How Does a Liquidity Trap Affect Investors?: Part 1

A liquidity trap occurs when the central bank keeps lowering interest rates all the way to zero in an effort to stimulate the economy but the economy does not respond as desired. This can be caused by banks being reluctant to lend despite the cash injections from the central bank or from a lack of demand for capital from businesses. If that part of the chain is not working the capital or liquidity becomes trapped between the banks and the potential borrowers in the economy.

A reluctance to lend or a lack of borrowing demand can be destructive because it could lead to lower production levels, lower consumption levels and possible deflation. This kind of trap has tied the hands of the Federal Reserve in the US because (with rates close to zero) one of its primary monetary policy tools to stimulate the economy (lowering rates) has been nearly used up.

It is theoretically possible to push capital into the economy despite the reluctance of lenders and borrowers by injecting it in the form of gifts (oops, pardon me, I meant “stimulus”). In this situation the Government can push money directly into the hands of favored businesses and individuals through direct investment, bailouts, asset purchases, infrastructure contracts, etc.

There are potential problems with handling a liquidity freeze like this.

  1. It can unintentionally feed the beast (bubble) that contributed to the recession by encouraging the same behavior with cheaper capital.
  2. The central bank has lost one of its primary tools to manage monetary policy and (unless rates are raised) it has fewer options available to stimulate the economy in the future.
  3. Artificial intervention on a large scale creates its own risk for bubbles. By artificially modifying market fundamentals the real possibility (and risk) of new asset bubbles becomes more likely.

A liquidity trap created by artificial intervention, like the one currently at play in the U.S. (as we write this), presents a lot of risks and potentially a few opportunities. Knowing where those risks and opportunities are can be a real benefit to retail investors active in the bond market.

[VIDEO] How Does a Liquidity Trap Affect Investors?: Part 2

The current liquidity trap in the U.S. has been partially created by the Federal Reserve engaging in quantitative easing to stimulate the economy. They do this by buying U.S. debt from banks in exchange for cash. Increasing the supply of cash in the hands of the banks is supposed to make capital cheaper for banks and businesses but so far demand for borrowing and a willingness to lend has not emerged as desired.

The buying pressure by the Fed combined with a broader flight into “safety” or government debt has driven demand through the roof. As demand for bonds increases, prices rise. At this point there is a real probability that we have merely exchanged an asset bubble in real estate, commodities and equities for one in bond prices. Prices have risen so far, the yield on 90 bonds is nearly zero and the 10 year yield is hovering at all time lows near 2%. Both of these are well below expected inflation rates over the debt’s term.

A sudden rise in selling pressure can pop just about any bubble and the more inflated it is the more extreme the correction may be. The current plans for deficit spending and stimulus in the U.S. will be paid for with new debt issues from the Treasury which could shift the balance between sellers and buyers enough to cause such a correction. The selling pressure from the Treasury could easily coincide with a decline in demand for U.S. debt, especially if the intended effect of the stimulus (growth) is realized.

If sellers enter an overbought market with additional supply may fall and could fall precipitously. Falling bond prices is a risk that bond holders should be aware of and prepared for. It is also an opportunity for speculators to benefit. For example, a trader could short bonds or bond ETFs or buy call options on yields. The 10 year note yield index (TNX) is optionable and long term calls could be an interesting opportunity for adventurous traders. I will cover this specific example in more detail in the video above. In the trading example I will be talking about buying calls on an index.


Image courtesy Kennymatic.