Flight to Liquidity and Global Equity Returns

Investment practice and academic literature suggest a great degree of interaction between the world’s stock markets and most liquid and safe assets, such as U.S. Treasuries. Using data from 46 markets and a 30-year time period, we examine the impact of “flight-to-liquidity” events on global asset valuation. This wide cross-sectional and time-series sample provides a natural setting for analyzing the link between changes in the illiquidity of Treasuries and expected equity returns. Our illiquidity measure is the average percentage bid-ask spread of off-the-run U.S. Treasury bills with maturities of up to one year. We find that this proxy predicts stock market illiquidity and future equity returns in both developed and emerging markets. This predictive relation remains intact after controlling for various world and country-level variables. Asset pricing tests further reveal that Treasury bond illiquidity is a significantly priced factor even in the presence of other conventional risks, such as those of the world stock market, foreign exchange, local equity market variance and illiquidity, as well as the term spread. Our results indicate that flight-to-liquidity risk is an important determinant of returns in global equity markets.