Revisiting Market Liquidity: The Case of U.S. Corporate Bonds

Prior to the financial crisis of 2007-2009, many people took market liquidity for granted. So, when the ability to convert assets into cash eroded, the issue became one of survival for some intermediaries. Today, both investors and regulators are focusing on “the ability to rapidly execute sizable securities transactions at a low cost and with a limited price impact” (see Fischer). And there has been an intense debate about whether post-crisis regulations themselves have diminished the supply of liquidity (see our earlier post)...

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The Fed: From forward guidance to data dependence

The goal of every central banker is to stabilize the economic and financial system—keeping inflation low, employment high, and the financial system operating smoothly. Success means reacting to unexpected events—changes in financial conditions, business and consumer sentiment, and the like—to limit systematic risk in the economy as a whole. But as they do this, policymakers try their best to respond predictably to news about the economy. That is, there is a central bankers’ version of the Hippocratic Oath: be sure you do not become a source of instability...

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The mythic quest for early warnings

Economists and policymakers are on a quest. They are looking for the elixir that will protect their economies from financial crises. Their strategy is to find an indicator that provides an early warning of collapse, and then respond with preventative measures.

We think the approach of waiting for warnings is seriously flawed. The necessary information may never be in our grasp. And even if it were, our ability to respond rapidly and effectively is far from clear. Rather than treating the symptoms of illness after they start to develop, we believe the better strategy is early immunization: the more resilient the financial system, the less reliance we will have on faulty or nonexistent warnings...

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The VIX: The only thing to fear is the lack of fear itself

The VIX has been called the fear index.  That is, it is a measure of the uncertainty and risk that investors see over the near future (specifically, the next 30 days).  Constructed from options on S&P500 index futures, the VIX is technically a gauge of what is called implied volatility. (For a definition, see the brief note at the end of this post.)

The technicalities are not all that important, as the VIX and similar options-based measures of implied volatility (like the DJIA Volatility Index shown with the VIX in the chart below) track financial conditions pretty well. When implied volatility is low, conditions are relatively accommodative; when it is high, they are restrictive.  Today, volatility is unusually low... 

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