What is a Flight To Liquidity
Flight to liquidity happens when investors attempt to liquidate positions in inactive or illiquid assets and purchase positions in more liquid assets.
Breaking Down Flight 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 in order to increase their ability to sell their positions on a moment's notice. This shift in assets is called a flight to liquidity. As this pattern 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 in that investors seeking to unload a security or investment due to fears of liquidity find themselves holding an increasingly illiquid investment.
Flights to liquidity are not uncommon 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 in terms of the economic concerns. With too many asset sellers and not enough buyers drives down asset prices, which can have a negative impact on economic outlooks and sentiment. Consumer and producer spending declines, slowing the economy and further justifying the 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.
Refuges During a Flight to Liquidity
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.