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The Implications of Liquidity on Economic Trends and Investment Dynamics - January 25th 2013

Written by guest contributor Eve Sharpe

The levels of liquidity in any given market dictate the threshold of investment activities in that market. Investment activities thrive when there are high levels of liquidity because individuals and organisations have more cash to spend and spare as well. This is particularly true in periods of economic prosperity when cash flows and credit availability run high. Lenders descend into the markets with differentiated loan products including business loans, auto loans, promissory notes, residential mortgages and non-residential mortgages. As such, corporate businesses, small business and individuals get to access wide ranging and affordable loan offerings. The Canadian Bankers Association reported that small business lending accounted for about $87.7 billion of the credit business in the Canadian banking industry in 2012.


However, liquidity levels cannot remain constant all the time because of various factors that are characteristic of economic fluctuations. Some factors such as credit availability enhance market liquidity while others such as inflation breed economic turbulence.


Consequences of Inflation

Investment trends in a country usually unfold in tandem with transformations within the larger domains of its economic activities. Inflation is a major economic factor that portends major implications on economic development relative to credit availability, productivity index, consumer consumption, employment, currency exchange rate movements and the overall gross domestic product (GDP). For example, the cost of living eases during periods of low inflation and rises rapidly when inflation shoots. Interestingly, inflation is itself a creation of excess liquidity that is generated by the ready availability of credit, albeit at high borrowing costs. This is because high productivity and income levels influence the willingness to indulge in costly borrowing to finance new and existing investments. The added borrowing costs are then passed on to consumers through increased prices of goods and services. Over time, this becomes unbearable to consumers as it gradually erodes their savings and purchasing power.


Taming Inflation

Central banks are responsible for halting or reversing inflation through appropriate policy measures that trigger credit scarcity. In Canada, for example, the Bank of Canada usually reacts with increments of the inter-bank lending rates (prime rates) whenever inflation spans out of control. This mops out the excess liquidity from the market because it becomes more expensive for commercial banks to borrow from the Central Bank. Commercial banks in turn pass the burden to their customers, thereby making credit more costly. The credit scarcity wanes the high productivity levels that spurred market confidence, and this leads to gradual drop in the prices of goods and services. However, interest rates fluctuations do not entirely wipe out the challenges of an ailing economy. Rather, they sometimes tend to generate volatility in some core investment sectors such as mortgage and stock markets.


The Nexus between the Stock Market and Mortgage Rates

The correlation between the stock markets and housing markets is fairly straight forward. This is because the two financial investment segments are highly interdependent. Stock market fluctuations have direct bearings on the market performance of mortgage-backed securities. During periods of stock market sell offs, investors generally transfer their proceeds to long-term fixed-returns investments such as mortgage-backed securities and bonds. When investor preferences shift to fixed-returns investments, the demand for the mortgage-backed securities rises and exerts a downward pressure on the mortgage rates. Similarly, when investors sell off their mortgage-backed securities and troop to equity stocks, the mortgage rates will rise. The higher rates may reduce capital flight and stimulate long-term investors to acquire more mortgage-backed securities.


Looking at it from the perspective of the adjustable rate mortgages, any stock market-driven interest rate fluctuations will affect the mortgage rates. Upward interest rates movements portend increments on adjustable rate mortgages and vice versa. Fixed-rate mortgages are similarly susceptible to happenings in the stock market. In the U.S., for example, a stock market sell-off that was experienced in August 2011 triggered sudden drops in 30-year fixed mortgage rates. The mortgage rates reportedly fell by significant margins following a slump in the stock markets that weighed down on interest rates. Such drops in the 30-year fixed mortgage rates stimulate demand from home buyers who generally hold out for such opportunities.


Trickle-Down Effects

Stock market shocks and the subsequent drops in interest rates further portend trickle-down effects on loan products for other sectors such as agriculture, manufacturing and the automotive markets. Reductions of interest rates in the housing market usually spill over to other types of assets that depend on credit financing. The spill-over reignites enthusiasm in credit markets as individuals and businesses find it more affordable to secure corporate financing, agricultural loans or loans for cars. In the auto markets, for example, more and more people are likely to line up for new auto loans as a result of the drops in average interest rates. Such was the case in Canada where CBC News reported that new auto sales rose by 7.8% in the period between October 2011 and October 2012 as a result of stable inflation. The opposite happens when inflation and vibrant stock markets push interest rates upwards. Indeed, inflation pushes interest rates for new car loans to prohibitive levels. This causes customers to shun loan offers for new cars.

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