- Michael Allison, CFA
- Jul 5
- 3 min read
Updated: Jul 7
By Michael Allison, CFA
Liquidity and Asset Allocation
Liquidity is like oxygen when it comes to investing, easy to take for granted when plentiful, but quite noticeable when it begins to disappear. This week’s Chart comes courtesy of Bridgewater Associates and offers a helpful visualization of the liquidity cycle and its influence on asset prices, particularly equities and bonds. It’s a simple, elegant framework that helps decode a complex macro environment.
The Chart breaks the liquidity cycle into four quadrants defined by the interplay between inflation, growth, and risk premiums. When liquidity improves, typically through falling interest rates, quantitative easing, or a reversal of tightening policies, risk premiums fall and asset prices rise. Equities and bonds both benefit, often with a tailwind to long duration assets. Conversely, when liquidity tightens, financial assets come under pressure and risk premiums expand. The rotation from risk-on to risk-off can be sudden and severe, as we’ve seen during past tightening cycles.
Understanding Liquidity
Liquidity, in this context, refers to the ease with which capital flows through the financial system. It’s shaped by central bank policy, short-term real interest rates, bank reserve levels, and credit availability. Tighter liquidity makes borrowing costlier and reduces access to capital. Looser liquidity conditions, whether from rate cuts, balance sheet expansion, or increased government spending, injects fuel into the economy and markets.
Where Are We Now in the Liquidity Cycle?
With the recent passage of the “Big Beautiful Bill” (a reference to the recently passed legislation combining infrastructure, defense, and clean energy investments), and the Fed signaling a pivot toward easing in the coming months, the liquidity environment appears to be inflecting to the positive.
Earlier this year, we were firmly in the upper-right quadrant of the chart: liquidity was tight, growth appeared to be slowing, and inflation was falling. That was a sweet spot for bonds, and indeed, the 10-year Treasury yield fell from its October highs. But in recent weeks, we’ve begun migrating clockwise—toward the lower-right quadrant, where liquidity improves and inflation stays in check. This is generally bullish for risk assets. Equities respond favorably as financial conditions ease and earnings expectations rise.
Implications for Asset Allocation
Six months ago, there was a case to be made for bonds. The Fed was still in restrictive mode, and equity valuations looked stretched in the face of decelerating earnings growth. Fast forward to today, and the S&P 500 just notched another all-time high. Inflation continues to moderate, and liquidity is poised to improve as rate cuts approach.
So where does that leave us? A few observations:
Equities: The shift to a more accommodative monetary stance could support higher P/E multiples. As liquidity improves and growth expectations stabilize and improve, that’s historically been good for stocks. However, with valuations rich, especially in megacap tech, selectivity matters. This may be a time to lean into quality cyclicals or small caps, which tend to benefit from a shift in the direction of the liquidity cycle.
Bonds: Duration still deserves a place in portfolios. While the initial bond rally was noteworthy, a more dovish Fed could re-anchor long-term rates. Bonds are still somewhat attractive, especially in intermediate Treasuries and high-quality corporates.
Relative Weighting: Without suggesting a meaningful change to portfolio allocations between stocks and bonds, some modifications within existing allocations might make sense. As mentioned before, leaning into more cyclical areas of the equity market and high quality small and mid-caps could prove beneficial to portfolios. Likewise, adding exposure to highly rated corporate credits, and potentially some areas of high-yield bonds, might also be timely.
Ultimately, liquidity is a force that amplifies market fundamentals. Right now, investor sentiment seems to be shifting toward optimism and renewed economic growth. For now, investors should be asking themselves, “Is my portfolio positioned to benefit from easier money and improving earnings expectations?”
Sources: Federal Reserve, Bloomberg, Wall Street Journal, Yardeni Research
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