Flight to Liquidity

What Is a Flight to Liquidity?

A flight to liquidity happens when investors attempt to liquidate positions in inactive or illiquid assets and purchase positions in more liquid assets. A flight to liquidity can be either a cause or a result of market panic.

A flight to liquidity is similar to a flight to quality, where investors reject risky assets in favor of low-risk ones. Since the most liquid assets also tend to be low-risk, it can be difficult to distinguish between a flight to quality and a flight to liquidity.

Understanding Flights to Liquidity

A flight to liquidity typically takes place during times of economic or market uncertainty. As investors grow increasingly concerned that markets may decline, they seek positions in more liquid securities that they can sell at a moment's notice. This shift in assets is called a flight to liquidity.

As this pattern of liquidation unfolds, investors increasingly view illiquid assets as uncertain or risky, thus further decreasing the implied value of these assets. The reduced demand pushes asset prices lower, which creates a positive feedback loop where investors race to sell off an increasingly illiquid investment.

How a Flight to Liquidity Occurs

Flights to liquidity are very common and may occur on a day-to-day basis on a smaller scale. In general, a flight to liquidity results from some sort of unexpected event. People react defensively or fearfully to this event and respond by liquidating assets and hoarding cash or cash equivalents, such as short-term Treasuries.

Such behavior, if sufficiently widespread, creates a self-fulfilling prophecy. When there are too many sellers and not enough buyers, asset prices fall and can have a negative impact on economic outlooks and sentiment. Consumer and producer spending declines, slowing the economy and further justifying their pessimism.

In this scenario, investors take on an overall bearish outlook, so they prefer to sell assets and hold more cash in expectation of lower asset prices in the near future. Developers and business leaders will typically defer new investment projects until after the storm passes.

Flight to Liquidity Investments

During a flight to liquidity, investors typically seek out those investments that are unlikely to be affected by any kind of market-wide contagion. The typical destination for these investors is low-risk bonds and cash equivalents, such as U.S. Treasuries, short-term certificates of deposit, commercial paper, and money market funds. Most U.S. investors can buy these assets through a broker, just like buying a stock or mutual fund.

Liquid investments typically do not generate much interest, and may not be able to keep up with inflation. However, they are less volatile than equities, allowing investors to preserve more of their wealth during a market downturn. Moreover, liquid assets can be easily sold, allowing investors to buy the dip when the market bottoms.

Special Considerations

The stock market is an example of a liquid market because of its large number of buyers and sellers. Because stocks can be easily sold through digital channels on an on-demand basis and for full market prices, equitable securities are considered liquid assets under the right conditions.

High trading volumes allow some equitable securities to quickly be converted into cash. This is especially the case for stocks with high market capitalization and large share volume. This is what makes stocks an attractive target during a flight to liquidity.

It should be noted, however, that some investors may deem equities too risky during a severe flight to liquidity, as they carry more short-term risk than many other liquid investments.

Cash equivalents are other investments that investors seek during flights to liquidity. Cash equivalents are investments that can readily be converted into cash and can include bank accounts, marketable securities, corporate bonds, Treasury bills, and short-term government bonds with a maturity date of three months or less. These are liquid and not subject to material fluctuations in value.

Real-World Example

An interesting example of a flight to liquidity occurred during the European sovereign debt crisis, lasting from 2009 to 2012. In the aftermath of the 2008 Great Recession, several states in the European periphery had accumulated unsustainable levels of debt, raising the possibility of a default.

As a result, lenders began to sell sovereign bonds in the most at-risk countries in favor of the less risky countries. Bond yields for peripheral countries, like Greece, Spain, and Italy, increased sharply during the crisis because those governments had to pay higher yields in order to borrow money. Yields fell in "core" countries, like Germany and France, because those countries had more investors willing to lend them money. In the case of Spain, the flight to liquidity resulted in yield changes of 80 basis points, or nearly 1%.