What happens when global liquidity dries up?

The rising tide of liquidity has led to the unprecedented growth of hedge funds and private equity deals. Yet what would happen in the markets if these popular investment vehicles came under threat?

In recent issues we have concentrated on the global liquidity story. This last two weeks the news has focused specifically on the yen based carry trade. The simple fact of the matter is that the massive growth in global liquidity has been outside the control of central banks'. A rising tide of liquidity, the scale of which dwarfs anything that has ever happened in the past. The outcome of this is crucial to the stability of the world's economies. Its emergence has caused a seismic growth in leverage and wealth, it has also caused an unprecedented growth in the number of hedge funds and private equity deals.

On 9th February the FT reported that US sub-prime problems might be an early warning signal of trouble for junk bonds. Martin Fridson, publisher of the Leverage World research service said that CCC rated US companies as a percentage of the high yield mix were 2% going into the 1990 recession. The latest figure he says is over 17%. There is according to him a 27% chance of CCC rated companies defaulting within 12 months of being given the rating. If the next recession is as deep as 1990 he says that US default levels will return to the levels of the Great Depression.

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