Recent research suggests that liquidity varies with economic conditions. This implies that there is a time-varying component in the pricing of liquidity. Previous literature has provided possible explanations in the time-variation in liquidity premium. Our research contributes to this branch of literature by examining whether the time-varying price of liquidity is affected by macroeconomic changes; more specifically, changes in real economic conditions, such as industrial production.
We follow the path of the previous research and focus on the macroeconomic effects on the price of liquidity. When economic conditions are deteriorating, funding liquidity is affected and market liquidity is considerably reduced, and the reduction in market liquidity in turn harms the funding liquidity. During a recession, improvements in real economic conditions can enhance stock liquidity and lower the price of liquidity.
Brunnermeier and Pedersen (2009) build a model which links market liquidity (the ease with which an asset is traded) with funding liquidity (the ease with which traders can obtain funding). They show that there is a mutually reinforcing relation between these two aspects of liquidity. Their model explains the empirically documented outcomes that market liquidity can suddenly become scarce when the economy is in a downturn. Thus, Brunnermeier and Pedersen (2009) predict that an exogenous shock to speculators’ capital should lead to a reduction in market liquidity.
The following papers empirically test the implications of the model in Brunnermeier and Pedersen (2009). Hameed, Kang and Viswanthan (2009) show that the level of market liquidity can suddenly decrease during a stock market decline. They also find that when this occurs it takes on average two weeks for the market to recover. Naes, Skjeltorp and Odegaard (2010) find a strong relation between stock market liquidity and the business cycle. Jensen and Moorman (2010) find evidence of a systematic link between monetary conditions and inter-temporal variation in the price of liquidity. Specifically, following an expansive monetary policy shift, funding and market liquidity conditions improve. This improvement is more beneficial for illiquid stocks.
Changes in interest rates, inflation rates, bond yields, Federal Reserve requirements and monetary policies can act as an exogenous shock to the funding constraints and influence funding liquidity. We observe that a substantial reduction in production activity results in a market decline in economic activity. Therefore, it is straightforward to use macroeconomic factors to describe different economic conditions and study macroeconomic effects on the pricing of stock liquidity.
