Washington, D.C., September 30, 2014 - Normalization of U.S. monetary policy will test the notion that the market calm and low volatility environment that has reigned over financial markets in recent years is but an "illusion of liquidity," created by and dependent on near-zero interest rates and will be reversed when rates rise, according to the latest IIF Capital Markets Monitor.

Liquid Primary Markets

The IIF noted that a clear impact of near-zero policy rates has been the evolution of very liquid primary market conditions in major mature market countries. Notably, non-financial corporates in both mature and emerging market countries have issued a record amount of bonds since 2008. This prompted a decline in corporate yields and spreads vs. government bonds to record or near record levels in 2014Q2. The IIF also raised concerns over the significant increase in borrowing by emerging market non-financial corporates, which have issued over $4 trillion of bonds in since 2008-pushing levels of EM non-financial corporate debt to over 80% of GDP, up from about 55% of GDP in 2007.

Less Liquid Secondary Markets

The IIF also noted that recent developments including regulatory changes have led to a deterioration in secondary bond market liquidity. Illiquid secondary markets could make adjustment to the normalization of monetary policy more difficult, if not disorderly, the IIF said.

The IIF noted that for many segments of the secondary fixed-income markets, many dimensions of market liquidity have shown signs of deterioration. These include declines in daily trading volumes, a reduction in the number of market-makers capable of maintaining large inventories of securities, and a reduction in trading size as well as a lack of depth in certain markets. Certain markets such as repo, which play a key supporting role, have also experienced reduced volumes.

Implications for the Future

The expected normalization of monetary policy in the U.S. and the UK raises two important issues, the IIF said:

1. How will the process of adjusting to higher interest rates be managed, given the risk of less-liquid secondary markets unable to cope with potential selling pressure-e.g., unwinding of long bond positions?
2. Have we reached a balance between containment of systemic risk and preserving the efficiency of capital markets?

The Institute of International Finance is the global association of the financial industry, with close to 500 members from 70 countries. Its mission is to support the financial industry in the prudent management of risks; to develop sound industry practices; and to advocate for regulatory, financial and economic policies that are in the broad interests of its members and foster global financial stability and sustainable economic growth. Within its membership IIF counts commercial and investment banks, asset managers, insurance companies, sovereign wealth funds, hedge funds, central banks and development banks. For more information visit www.iif.com.