These Three Events Will Shatter "Liquidity Illusion", Trigger Crisis, OECD Says

The OECD has released its first Business and Finance Outlook which the organization describes as “an annual publication that presents unique data and analysis that looks at what might affect and change.. tomorrow’s world of business finance and investment.” 

Over some 250 pages, the first edition offers a sweeping look at the global financial landscape and outlines, in excruciating detail, many of the major themes we’ve built on in these pages including companies’ propensity to spend on buybacks and dividends at the expense of capex, the dangers of employing unrealistic pension fund investment return assumptions in a ZIRP world, and, of course, the liquidity paradox, wherein trillions in central bank cash injections mask underlying illiquidity — especially in bond markets. 

Here’s how Reuters summarizes the report:

Encouraged by years of central bank easing, investors are ploughing too much cash into unproductive and increasingly speculative investments while shunning businesses building economic growth, the OECD warned on Wednesday.


In its first Business and Finance Outlook, the Organisation for Economic Cooperation and Development highlighted a growing divergence between investors rushing into ever riskier assets while companies remain too risk-averse to make investments.


It urged regulators to keep a close eye on investors as they piled into leveraged hedge funds and private equity and poured cash into illiquid assets like high-yield corporate bonds.


Meanwhile, judging by stock market returns, investors were rewarding corporate managers focused on share-buybacks, dividends, mergers and acquisitions rather than those CEOS betting on long-term investment in research and development.

And here is the OECD’s take on the “liquidity illusion”:

There appears to be some illiquidity illusion in these trends. There has been a veritable “super-highway” of inflows into these “liquidity premium” products: corporate and emerging corporate credit, private equity and alternative assets. The “Super highway” into these products is not a dual carriageway — and when investors want to sell in a stressed environment they may find that there will be “accidents” in the reversal of flows.


High yield bonds have reduced liquidity due to declining covenant protection, making them harder to sell in a stressed event.


ETFs and alternative products that offer daily liquidity through trading in secondary markets when referencing illiquid underlying securities could be severely tested by redemptions in a sell off even where shares must be redeemed for in kind securities rather than cash.


Among the triggers the OECD says could spark a “liquidity crisis” are: 1) monetary policy normalization, the return of the EMU debt crisis, 2) a “falling oil price surprise” which could, in the organization’s words “undermine the oil-related and fracking business investment in the US,” 3) and geopolitical turmoil in the Middle East and Eastern Europe.


“Any of these events would likely trigger asset price volatility [and] attempts by institutional investors to redeem illiquid corporate bonds in crisis circumstances would amplify volatility.”

Once again we see that the proliferation of HY bond funds and other esoteric products (that have attracted unprecedented inflows in an environment where risk free assets yield at best an inflation adjusted zero and at worst have a negative carry) is cause for serious concern among very "serious" people who, years after the issue was first raised here, are now suddenly coming to the realization that when the market finally turns (due either to a poorly executed Fed liftoff or a geopolitical catastrophe), and previously diversifiable flows suddenly become a one-way rush to the exits, fund managers will be forced to sell the underlying assets, and in the absence of dealer liquidity (which has all but dried up in the post-crisis regulatory regime) a self-feeding firesale will ensue at which point central banks will either do as the IMF recently suggested and become market makers of last resort, or watch in horror from the sidelines as the bubble blown by allowing otherwise insolvent corporate issuers to stay afloat by tapping capital markets at artificially suppressed rates implodes in spectacular fashion.

Grab some popcorn.