Credit analyst says markets signal tightening liquidity through mid-year

By Ronda Fears

Nashville, Feb. 20 - Liquidity in the financial markets is tight right now and the markets are signaling further tightening at least through mid-year, said CreditSights analyst Reena Mithal.

The firm introduced Thursday a monthly market liquidity index constructed as an integrated measure of liquidity conditions in U.S. equity, fixed-income and currency markets. Components of the index include the ratio of corporate to Treasury yields, two-year swap spreads, the VIX volatility index and real trade-weighted dollar prices.

The index traces the path of quarter-over-quarter GDP growth two quarters ahead.

When risk aversion rises, yields and volatility increase, causing liquidity to tighten.

"Major indices and benchmarks incorporate expectations on individual securities, and on overall market and economic conditions," Mithal said in a report on the index.

"We have built an index that provides an integrated measure of liquidity in U.S. equity, fixed income and currency markets in an effort to track what markets are saying about current conditions and the state of the economy over the following two quarters.

"The index is currently signaling a further tightening in liquidity conditions, implying a negative outlook through the second quarter of this year. It is approaching 10-year lows that were observed through 1Q99."

Components of the index are proxies for developments in fixed-income, equity and currency markets, reflecting investor perceptions of risk in U.S. government securities, corporations and the dollar.

The index also captures the impact of U.S. monetary and fiscal policy through baseline interest rate movements, the cost of funding for corporates and Treasury yields - incorporating both expectations of political and economic uncertainty plus the impact of potential changes in supply of U.S. government debt.

The ratio of corporate to Treasury yields is an indicator of conditions in U.S. credit markets and investor expectations about the creditworthiness of large corporate borrowers.

Two-year swap spreads expresses the prevailing view on credit spreads as well as risk-free bonds.

"An increase in swap spreads reflects a flight to quality as investors react to higher systemic risk by moving out of credit product into government paper," she said.

"Swap spreads also communicate the market's view on monetary policy and the shape of the yield curve. Lower spreads indicate more financial liquidity, as a result of some combination of an easing interest rate environment and a new wave of Treasury issuance."

The VIX is the market estimate of future equity volatility and "has become an increasingly potent proxy for investor sentiment in the past five years," Mithal said.

For the index, she said the U.S. dollar is observed purely as a proxy for capital flows, since a strong dollar increases liquidity as it pulls foreign investors to U.S. markets and deters domestic investors from investing overseas.

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