Overnight for most traders, but on Friday for the Asian session, there was a bit of panic in Chinese markets. The issue appears to be resolved, but it brought up something that really worries seasoned traders: Lack of liquidity.

In a move aimed at shoring up the markets, Chinese lenders issued a bunch of short-term debt in a high interest rate environment. Typically, this is something that only happens in emergencies, and it could well be that this was just a passing urgency. But, since it’s something that a lot of traders who have recession on their mind might be thinking about, it’s worth a deeper dive. Because there is a similar issue in Europe and America at the moment.

Warning: Liquidity Too Low

Chinese lenders doubled their short-term lending in one week, the largest increase on record. This was meant to meet demand for liquidity as banks are facing a cash crunch. The government is issuing record amounts of debt in order to pay for economic stimulus, which is hoovering up all available cash. For a brief moment, there was considerable concern that some banks wouldn’t have enough to find financing. Some financial institutions were forced to pay rates of up to 50% in order to secure liquidity.

By the end of trading on Friday, the situation had normalized. Though there were once again calls for the PBOC to ease rates and help increase liquidity in financial markets. With China having slipped into deflation, the central bank is in a much better position to ease, which might help contribute to markets not entering in full-on panic mode.

It’s Kind of a Global Problem

That’s not the situation in the United States, where the Federal government is also issuing massive amounts of debt. The US Treasury is expected to borrow up to $776B this quarter, which is actually down from the $1.0T that it took out of the markets last quarter. Meanwhile, the Fed is in the process of selling around $270B in bonds through that period.

The Fed’s reverse repo facility fell below $1.0T for the first time since the middle of 2021. That’s significant because the reverse repo is where banks put the “extra” money that financial institutions have. That’s money that could be used to buy up bonds. The last two Treasury auctions garnered significantly less interest, as more and more traders bet that yields will keep rising as the government is forced to borrow more money. Bloomberg reported earlier in the week that interest payments on US Federal debt is expected to cross the $1.0T threshold this year, making it the third largest expense (after social security and health care).

Running Out of Money is Bad

Typically, a liquidity crunch precedes a market crash. Most trading is done on margin, which considers profitability on the basis of the cost to borrow for that margin. If interest rates go up suddenly, because there is little money around to loan out, then this can force traders to sell positions, since they can’t afford the margin. The sudden drop in price then leads to a cascade of selling.

For now, the regulators insist that the markets are well capitalized and there is plenty of liquidity. However, the disappointing Treasury auctions and the (momentary) spikes in borrowing costs suggest that the market is under liquidity strain. Traders might want to keep an eye on developments in this area over the coming days and weeks to see if it irons out.

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