It also occurs when interest rates are high since that makes it expensive to take out loans. It also includes non-liquid assets like stocks, real estate, and high-interest loans. Large financial institutions that make most investments prefer using borrowed money. Since the Great Recession, they've shied away from credit card debt.
They've also taken advantage of low-interest rate loans to buy cars and get an education. It's too soon to say whether these consumer spending trends are permanent or just a reaction to the recession.
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High liquidity means there's a lot of capital. But there can be too much of a good thing. A liquidity glut develops when there is too much capital looking for too few investments.
That leads to inflation. That leads to " irrational exuberance. They create an asset bubble. Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets.
Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before prices drop further. That's what happened with mortgage-backed securities during the subprime mortgage crisis. It usually leads to a recession. Constrained liquidity is the opposite of a liquidity glut. It means there isn't a lot of capital available or that it's expensive.
It's usually a result of high-interest rates.
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It can also happen when banks and other lenders are hesitant about making loans. Banks become risk-averse when they already have a lot of bad loans on their books. Families and businesses are afraid to spend no matter how much credit is available. Workers worry they'll lose their jobs, or they can't get a decent job.
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They hoard their income, pay off debts, and save instead of spending. Businesses fear demand will fall off even more, so they don't hire or invest in expansion. If your portfolio is invested in suddenly-volatile markets, you can pull out your money and park it in a money market fund.
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Although the returns may be in the low single digits, it's a very low-risk place to keep your money in a down market. Investments in money market funds are typically liquid, meaning you can usually get your money out within a few business days. You can also take advantage of rising interest rates by keeping your money in an investment that will adjust to the markets.
A lot of institutions allow you to write checks to withdraw your funds from a money market fund. Therefore, you get the advantages of dividend earnings as well as easy access to your cash. Make sure you ask what restrictions or fees your institution has. There are several risks that are worth highlighting.
First, a money market fund is technically a security. If the share price goes down, you can lose some or all of your principal. The U. This leads to the next risk, which is that money market funds are not FDIC insured.
Although money market funds are extremely safe, there is still a small element of risk that you could lose money, without any government entity to cover your losses. Next, money market fund rates are variable. The rate could go up or down. If it goes up, that may be a good thing. However, if it goes down and you earn less than you expected, you can end up needing more cash. This is the same as other securities investments but is still worth noting if you're looking for dependable and predictable returns on your funds. A final risk that comes with money market funds has to do with opportunity costs and inflation.
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Because money market funds are considered to be safer than other investments like stocks, long-term average returns on money market funds tend to be less than long-term average returns on riskier investments. For example, common stock returns average out to 8 percent to 10 percent over time, while money market mutual funds come in at only 2 percent to 3 percent on average.
Over long periods of time, inflation can eat away at your returns, and you might be better served with higher-yielding investments. When it comes to money market funds, you have choices.
Related Credit Treasury: A Credit Pricing Guide in Liquid and Non-Liquid Markets
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