Share prices are falling, the Norwegian krone is plummeting and the risk premiums in the fixed income market are increasing. This we have seen before.
What is new is not only how fast it has all happened, but also the reasons why.
We have had event-driven shocks in the market in the past as well, such as wars, oil price shocks or terrorist attacks. However, it is more than a hundred years since last a pandemic virus, the Spanish flu, hit the economy. Very few saw the coronavirus coming, and how hard it would hit the economy and the markets.
The result of the turmoil is that there is a lack of money in the financial markets and this is also why governments and central banks are coming to the rescue.
Five reasons why liquidity in the Norwegian market has weakened:
1. COVID-19 Lockdown
The authorities in Norway, like in most European countries, have ordered their inhabitants to stay at home as much as possible to prevent an exponential spread of the coronavirus. Shops have closed or have very limited opening hours, schools have introduced homeschooling, social events, as well as concerts and sports events, are banned, and our borders are closed.
A lot of companies lose revenue, employees are laid off and the result is – predictably – falling share prices.
2. Saudi Arabia Launched an Oil Price War Against Russia
As economic activity has declined due to the virus, the demand for oil is also reduced. Lower demand leads to lower oil prices. On top of this, Saudi Arabia launched an oil price war to hit the oil production in Russia and the US by increasing its supply. Lower demand and higher supply caused oil prices to plunge.
Norway is an oil-fueled economy where our currency often reacts in tandem with the oil price. As the price of a barrel of North Sea crude oil fell nearly 30 per cent overnight on the 8th of March, we woke up to an even weaker currency, making Norwegian investments less attractive to foreign investors.
3. Currency Hedging of Equity and Bond Positions
The Norwegian krone has depreciated dramatically and more than during the financial crisis. While this helps offset the losses for those with unhedged foreign positions, it also means that everyone who has hedged their foreign investments does not get any “help” from the weaker currency. The latter must pay large sums in new collateral, which in turn withdraws money from the market.
New collateral requirements are also felt by those who have borrowed money to invest. They have to provide cash as collateral after the fall in prices. This takes money out of the financial market. Liquidity is also withdrawn from the market with anyone who needs to (or wants to) sell their equity and bond positions due to the fall in prices.
4. A Global Shortage of US dollar Weakens the Norwegian krone
In times of turmoil in the financial market, there is an increasing demand for safe havens. The U.S. dollar is often seen as a bedrock of the global economy and a reserve currency for international trade and finance. In the fixed income market, US government bonds is also seen as a haven.
This means that the demand for dollars is increasing quickly. Consequently, the dollar strengthens and it has become more expensive to buy US dollars. In a global financial market, the lack of dollars means that Norwegian money market rates are also increasing, even though the central bank rates have been cut.
5. Rebalancing Leads to Selling Pressure of Bonds
Many investors follow different types of rebalancing strategies to safeguard themselves from undesirable risks. The most common strategy is to try to maintain a balance between the value of equities and bonds in a portfolio. When stocks rise in value, the strategy calls to sell stocks in order to maintain the original balance. When stock values decrease, the strategy calls to buy more shares. The money to buy more shares is largely taken from bonds, which leads to an increased redemption in bond funds which in turn leads to deteriorating liquidity in the fixed income market. Corporate bonds, in particular, have lower liquidity and are thus particularly vulnerable now.
The liquidity squeeze has led to an increase in money market rates
We now see that higher liquidity premiums, as well as greater credit premiums, have led to an increase in money market rates. I was a fixed income portfolio manager during the financial crisis and we saw the same thing happening back then.
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