Liquidity is tightening, which increases risks
Since my last column Is there a stock market bubble? Here are the warning signsthat was about spotting bubbles, there have been subtle shifts in the risk positions of major global investors, suggesting that you should now behave more cautiously than before.
Some of this behavior has been reflected in the relative outperformance of defensive sectors such as healthcare and utilities, beat technology, artificial intelligence (AI) and defense over the past month. And some of the same behaviors also reflect the changing picture of liquidity, which is of course the fuel that inspires all thematically driven rallies.
This article was first published in The Australian on October 30, 2025.
In a major update from Federal Reserve (Fed) Chairman Jerome Powell at the Blockworks Digital Asset Summit (DAS) in London, it was revealed that the era of ‘quantitative tightening’ (QT) may be nearing an end. While this may seem like a small technical shift, it signals much more than a change in central bank policy. While the left hand signals a return to quantitative easing (QE), which should be good for markets, it masks the tightening of liquidity on the right hand. If cash becomes harder to come by, it will cause stress on money markets and possibly lead to a stock market downturn.
Liquidity refers to the ease with which assets, such as cash or bonds, can be bought or sold without causing a dramatic change in price. Under normal circumstances, liquidity is abundant, allowing investors and institutions to move money quickly through the financial system. However, when liquidity tightens, it can create bottlenecks in the markets, making it difficult for financial institutions to function smoothly.
Recently, signs of liquidity problems have been reported, especially in the US repo markets. A repurchase agreement (repo) is a secured short-term loan, usually overnight, where one party sells a security (usually government bonds) to another party with an agreement to repurchase it the next day or within a short period of time at a slightly higher price. The difference between the initial sales price and the repurchase price represents the interest on the loan, called the repo rate.
Repo markets allow financial institutions to manage their short-term liquidity needs. For example, banks can borrow money overnight to meet reserve requirements or funding shortfalls, and they can pledge government bonds or other high-quality assets as collateral. This helps them avoid having to sell assets at inopportune times or under adverse circumstances.
Central banks, like the US Fed, also use the repo market to implement monetary policy. When the central bank wants to inject liquidity into the system, it buys government bonds through reverse repos (a type of repo transaction in which the central bank buys securities and agrees to sell them back at a later date).
And when the central bank wants to tighten liquidity or control inflation, it sells securities to banks through repos, taking money out of the system.
By adjusting conditions, central banks can influence short-term interest rates and the overall level of liquidity in the economy.
When liquidity becomes tight, borrowing costs rise and the frequency of borrowing increases as institutions rush to meet their short-term needs. And this is what seems to be happening in the repo markets today: Borrowing has soared, with volumes reaching $8.35 billion in just one day.
Why should you care?
When repo rates rise or liquidity becomes scarce, it can cause a chain reaction that impacts other financial markets, such as stocks, bonds and even commodities like gold and bitcoin. It also indicates that there are increasing imbalances between cash reserves held by banks and the liquidity needed to meet market demand.
For years, the Fed has been seen to be shrinking its balance sheet after a period of aggressive quantitative easing to support the economy during the pandemic. Instead of pumping money into the system, the Fed reduces the amount of money circulating. This tightening of liquidity is intended to keep inflation under control.
The problem is that as the Fed reduces liquidity, it also increases the likelihood of a liquidity crisis. The danger, however, is that the Fed’s current solution – Powell’s recent hints about the end of QT – may not be enough to solve the problem that appears to be reflected in the repo markets.
Stocks, bonds and cryptocurrencies depend on abundant, if not excessive, cash flow and credit availability. If investors and institutions do not have easy access to funds, they are less likely to take on risky investments. In the case of stocks, this means a decrease in buying activity, potentially causing prices to fall as investors sell in ‘anticipation’ of price falls! Yes, we have indeed reached the point where investors are now just guessing what other investors are going to guess.
Historically, a decline in liquidity has been followed by a decline in asset prices, particularly stocks, gold and Bitcoin.
The cause of the liquidity problem lies in a growing shortage of reserves at American banks. The Fed has made clear that it has no precise measure of the “adequate” level of reserves, but estimates suggest that banks need about $3.3 trillion in reserves to function smoothly.
When reserves decline and borrowing costs rise, pressure on money markets becomes apparent. This is further complicated by the fact that much of the world’s financial activity is based on debt refinancing, where borrowed money is used to repay existing debt. As liquidity comes under pressure, it becomes more difficult for institutions to refinance their debt, increasing market volatility amid rising uncertainty.
And currently, independent analysts estimate reserves remain below $3.3 trillion, exacerbating tensions in repo markets and potentially fueling greater volatility elsewhere.
What does this mean for investors?
The Federal Reserve (the Fed), the main source of liquidity in the US, may have to do more than just end the QT interval to prevent the development of a prolonged market downturn. Without more generous actions on the Fed’s part, investors could be running on borrowed time.
And the problem extends beyond US markets. Global liquidity is also tightening, albeit to varying degrees. In China, for example, central bank injections have helped boost liquidity, while in Japan and Europe liquidity growth is slowing. The result is more cautious investor sentiment, with funds flowing from developed markets, such as the US and Europe, to emerging markets such as China, where liquidity conditions are more favorable. And last month they left the leading technology and AI companies for the more defensive healthcare and utilities sectors.
When liquidity is plentiful, markets perform well, but when liquidity tightens, you need to be careful.
This article was first published in The Australian on October 30, 2025.
He is also the author of the best-selling investing guide to the stock market, Value.able – how to value and buy the best stocks for less than they are worth.
Roger regularly appears on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
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