The pandemic, Fed interest rate policy and bond purchases, restrictive banking regulations, and banks’ swelling cash balances will have a lingering impact on liquidity and produce some mind-bending policies to deal with this uncharted territory.
As the pandemic emerged in March 2020, strange things happened:
o Bond markets seized up and investors panicked.
o Bond yields spiked causing severe price declines.
o Credit default swap prices (debt protection derivatives) rose 100x in less than a month.
o The dollar rose and liquidity dropped for U.S. Treasuries, usually the world’s most liquid security.
o There was substantially lower demand at U.S. Treasury auctions.
The Federal Reserve responded with an almost never-ending pile of cash, buying vast quantities of bonds with newly created cash. It has continued its purchases, at a pace of at least $120 billion a month.
But this has not resulted in “happy days are here again.” This mountain of dollars is limiting liquidity and constraining markets. That’s right, read that again if you must – too much cash can constrain the economy.