Liquidity is tightening, so risks are rising
Since my last column Is there a stock market bubble? Here are the warning signs, which was on the topic of recognising bubbles, subtle shifts have been occurring in the risk postures of major global investors that suggest you now need to behave more cautiously than before.
Some of those behaviours have been reflected in the relative outperformance over the last month of defensive sectors such as healthcare and utilities, beating technology, artificial intelligence (AI) and defence. And some of the same behaviours also reflect the changing picture of liquidity, which, of course, is the fuel that inspires all thematically driven rallies.
This article was first published in The Australian on 30 October 2025.
In a major update from Federal Reserve (Fed) Chair Jerome Powell at the Blockworks Digital Asset Summit (DAS) in London, it was revealed the era of “Quantitative Tightening” (QT) may be nearing its end. While this seems like a minor technical shift, it signals much more than a change in central bank policy. While the left hand signals a return to Quantitative Easing (QE), which should be good for markets, it masks tightening liquidity by the right hand. If cash becomes harder to come by, it will cause stress in money markets and potentially lead to an equity market downturn.
Liquidity refers to the ease with which assets, like cash or bonds, can be bought or sold without causing a dramatic shift in price. In normal conditions, liquidity is abundant, allowing investors and institutions to move money swiftly through the financial system. However, when liquidity tightens, it can create bottlenecks in markets, making it difficult for financial institutions to operate smoothly.
Recently, signs of liquidity problems have been reported, especially in the U.S. repo markets. A repurchase agreement (repo) is a short-term secured loan, typically overnight, where one party sells a security (usually government bonds) to another party with an agreement to repurchase it at a slightly higher price the following day or within a short period. The difference between the initial sale price and the repurchase price represents the interest on the loan, called the repo rate.
Repo markets allow financial institutions to manage their short-term liquidity needs. Banks, for example, can borrow money overnight to meet reserve requirements or funding gaps, and they can pledge government bonds or other high-quality assets as collateral. This helps them avoid having to sell assets at inopportune times or under unfavourable conditions.
Central banks, like the Fed in the U.S., also use the repo market to implement monetary policy. When the central bank wants to inject liquidity into the system, it buys government securities via reverse repos (a type of repo transaction where the central bank buys securities and agrees to sell them back at a later date).
And when the central bank wants to tighten liquidity or control inflation, it sells securities to banks through repos, pulling money out of the system.
By adjusting the terms, central banks can influence short-term interest rates and overall liquidity levels in the economy.
When liquidity becomes tight, borrowing costs rise, and the frequency of borrowing increases as institutions scramble to meet their short-term requirements. And this is what seems to be occurring today in the repo markets: borrowing has surged, with volumes reaching US$8.35 billion in just a single day.
Why should you care?
When repo rates rise or liquidity becomes scarce, it can spark a chain reaction that impacts other financial markets, such as stocks, bonds, and even commodities like gold and bitcoin. It also indicates that there are growing imbalances between cash reserves at banks and the liquidity needed to meet market demand.
For years, the Fed has been seen to be shrinking its balance sheet after a period of aggressive QE to support the economy during the pandemic. Instead of pumping money into the system, the Fed reduces the amount of money circulating. This tightening of liquidity is intended to control inflation.
The problem is that as the Fed reduces liquidity, it also raises the likelihood of a liquidity crisis. The danger, however, is that the Fed’s current solution – Powell’s recent hints about the end of QT – might not be enough to solve the problem that seems to be reflected in repo markets.
Stocks, bonds, and cryptocurrencies rely on an abundant, if not excessive, flow of money and credit availability. If investors and institutions can’t access funds as easily, they’re less likely to take on risky investments. In the case of stocks, this means a decrease in buying activity, potentially causing prices to drop as investors sell, ‘in anticipation’ of prices dropping! Yes, we have indeed reached the point where investors now merely guess what other investors are going to guess.
Historically, a fall in liquidity has been followed by a drop in asset prices, particularly equities, gold and Bitcoin.
The root of the liquidity issue lies in a growing shortfall of reserves held by U.S. banks. The Fed has been clear that it doesn’t have a precise measure for the “adequate” level of reserves, but estimates suggest banks need around US$3.3 trillion in reserves to function smoothly.
When reserves decline, and borrowing costs rise, a strain on money markets becomes evident. This is further complicated by the fact that much of the world’s financial activity is based on debt refinancing, which involves using borrowed money to repay existing debt. As liquidity becomes more strained, it becomes more difficult for institutions to refinance their debt, heightening market volatility amid the rising uncertainty.
And currently, reserves are estimated by independent analysts to be falling short of that US$3.3 trillion, exacerbating tensions in the repo markets and potentially leading to increased volatility elsewhere.
What does this mean for investors?
The Federal Reserve (the Fed), which is the main source of liquidity in the U.S., may need to do more than just ‘end QT’ to avoid the development of a prolonged market downturn. In the absence of more generous actions on the part of the Fed, investors could be running on borrowed time.
And the problem extends beyond U.S. markets. Globally, liquidity is also tightening, albeit at different rates. In China, for instance, central bank injections have helped boost liquidity, while in Japan and Europe, the growth of liquidity is slowing down. The result is more cautious investor sentiment, with funds rotating away from developed markets, like the U.S. and Europe, and into emerging markets like China, where liquidity conditions are more favourable. And last month they rotated away from the leading technology and AI companies into the more defensive healthcare and utilities sectors.
When liquidity is abundant, markets perform well, but when liquidity tightens, watch out.
This article was first published in The Australian on 30 October 2025.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
