University of Bath: Rising interest rates may trigger liquidity crisis and price falls in global stock markets

Global central banks responding to spiralling inflation with aggressive interest rate hikes may trigger a liquidity crisis, high volatility and price falls in global stock markets, new research from the University of Bath shows.

The study of banking stocks between 2003 and 2012, which encompassed the global financial crisis, also showed that uncertainty about central banks’ policy decisions adversely affected market liquidity as investors, spooked by fears of even tighter monetary policy, shifted their money to lower risk areas.

“The global financial crisis illustrated starkly how increased funding costs and changes in market liquidity can trigger stock market failures. Our research has demonstrated that excessive financing spreads can harm market liquidity, leading to increased asset price volatility and stock market uncertainty,” said Dr. Ru Xie of the university’s School of Management.

Xie, who co-authored the study Bank funding constraints and stock liquidity with Professor Philip Molyneux and Binru Zhao from Bangor Business School, and Dr. Qingwei Wang from Cardiff Business School, said the research identified that uncertainty over central banks’ monetary policies reduced investors’ willingness to assume risk as it increased their fears of future asset price volatility – further reducing market liquidity.

“In financial crisis and periods of market uncertainty, investors switch funds to where they feel it is safer. This flight to safety can lead to a huge shortage of liquidity, which forces banks and financial firms to fire-sell securities to meet increased liquidity demand, which in turn depresses financial sector share prices,“ Xie said.

The research found, however, that proactive and prudent macroeconomic policies could play an important role in breaking the vicious circle of a liquidity crisis. Xie suggested that a more gradual approach to tighten monetary policy could offer one path to fighting the inflationary pressures preoccupying central banks currently.

“The key is finding a balance between addressing inflation and triggering a dangerous liquidity crisis. The risk is that ever-tighter monetary policy and interest rate hikes taken in very large steps will increase funding costs for financial institutions, and generate a liquidity crisis, which will increase the risk of global recession. Central banks, focused on rates and inflation, must also be aware of the dangers of a liquidity crisis,“ Xie said.

The U.S. Federal Reserve announced a 75-basis-point rate increase on Wednesday. That, combined with increases in March, May and June, has raised the central bank’s overnight interest rate from near zero to a level between 2.25% and 2.50%.