Nervous investors are abandoning the securities markets at an accelerating pace, causing a significant drop in liquidity that has worrisome parallels with the opening stages of the 2008 financial crisis, according to a report from Deutsche Bank. The crisis a decade ago helped to produce a severe global economic recession and sent stocks plummeting worldwide, with the S&P 500 Index (SPX) losing more than half its value in a deep bear market.

Significance For Investors

The risk is that today's plunge in liquidity will produce increasingly higher volatility in the form of giant swings in financial asset prices, according to the Deutsche Bank report cited in detail by Business Insider. In 2008 of course, those swings led to sharp overall stock declines, rather than gains. "We recall that the unwinding of quant funds in August 2007 and macro funds in October 2015 were harbingers of subsequent market turbulence," Deutsche Bank observes. They note that hedge fund redemptions have surged since October of 2018. Meanwhile, cash and cash equivalents have been among the best performing assets in 2018 as investors pare their holdings of stocks and bonds, per another Investopedia report.

Veteran billionaire investor Stanley Druckenmiller, formerly lead manager of the Quantum Fund founded by George Soros, has voiced similar concerns. "With the monetary tightening, we're kind of at that stage of the cycle where bombs are going off," he warned, as quoted in a prior Business Insider article. "It's going to be a shrinkage of liquidity that triggers the whole thing," he added.

Stating that liquidity is diminishing in the financial markets is another way of saying that the number of willing buyers, and the amount of funds that they are willing to commit to their purchases, are declining. This, in turn, means that sellers have to accept lower and lower prices to entice buyers and liquidate their own investments.

Another factor is the changing role of the world's central banks. A decade ago, they staged a massive intervention, including bailouts of systemically important financial institutions (SIFIs) and unprecedented purchases of bonds on the open market, called quantitative easing (QE). This proved necessary to avert a global economic and financial meltdown. Today, however, the U.S. Federal Reserve has begun a massive reversal of QE, paring its balance sheet by letting its bond holdings mature without reinvesting the proceeds. This represents a significant withdrawal of liquidity from the financial system, and the removal of a key prop to financial asset prices over the past ten years.amu

Additionally, the Fed is committed to battling inflation with interest rate hikes. This policy initiative also is adding to the appeal of cash and cash equivalents relative to stocks and bonds, further reducing market liquidity. In this vein, a recent report from banking giant HSBC names two major risks for 2019 as Fed rate hikes and a U.S. corporate bond market that already has become "structurally illiquid." HSBC cited these as two of the 10 biggest risks for the world economy and financial system in 2019, per Investopedia.

Looking Ahead

Whether or not a new financial crisis is on the horizon depends on many factors. One is whether the world economy remains strong or slips into recession. Another is whether bank deregulation in the U.S. has removed unnecessary impediments to profitability or removed prudent safeguards against a new crisis even amid a U.S. economy whose outlook appears healthy.