Happy new year!
To this lay observer, it seems obvious that the global financial system has become addicted to not only low-interest rates but also to the constant balance sheet interventions of quantitative easing. In a sense, this addiction is almost physical. Cross Border Capital, a London based research house, argues that collectively central banks have “an outsized-effect in deregulated financial systems, where retail deposits are not the sole funding source because what matters most is the ability to re-finance positions and at the margin, Central Banks are the marginal suppliers of liquidity.”
So, in a very practical sense, the global commercial position is addicted to liquidity provision by banks, not at the margins but within the core of financing. There are various transmission mechanisms for this liquidity addiction including central bank involvement with the underpinning of the money market system, but the net effect is a kind of ‘crowding out’ of traditional private sector sources of liquidity. Central banks simply become an easier source of funding.
This all matters because the US Federal Reserve provides the central valve, or should we say spigot that provides liquidity to the global financial system. As this liquidity mechanism begins to falter or constrict, it’s reasonable to assume that the rest of the world will follow, if only through the transmission system provided by dollar liquidity. Which is precisely where we are now – the primary liquidity system is now tightening at a surprisingly fast rate, largely because the US Fed is trying to shrink its balance sheet. On its own, the global financial system could survive this ‘tightening’ but other central banks such as the ECB and the BoJ are also tightening at the same time. This is, in turn, having a chilling effect of dollar-denominated liquidity for emerging market banks and borrowers. And, according to Cross Border, there is one final additional source of fiscal tightness to reckon with – a regulatory and legislative “onslaught against the Eurodollar /offshore wholesale markets”.
Combine these all together and we have the mother of global liquidity squeezes. According to Cross Border since the end of January 2018, world private sector liquidity has fallen by some US$3 trillion, with roughly two-thirds of the drop coming from the Developed Economies. Global Central Bank liquidity has fallen by another US$1.1 trillion, with two-thirds of its drop recorded in Emerging Markets.
“Added together, Global Liquidity has in total fallen by just over US$4 trillion to US$124.1 trillion. This 3% drop looks more serious when set against its 7% ‘normal’ trend. Put another way, after its brief recovery Global Liquidity has fallen back again to stand some 25% below its long-term trend”.
The chart below from Cross Border nicely sums up the current situation as regards domestic liquidity in the G4 economies.
My hunch is that investors are, in some senses, looking in the wrong place when they worry about central banks increasing interest rates. They should be much more worried by the fact that the biggest single providers of primary liquidity to the global capital markets – central banks – are now tightening like crazy. We’ve already seen a new version of taper Tantrums occur after recent Fed rate rises, all of which makes one imagine one possible nightmare scenario. In order to fend off populist policy makers, central bankers might slow down the rate of increase in interest rates – a very overt measure – whilst also intensifying the liquidity squeeze. If this did happen, the impact could be cataclysmic.
My own sense is that we are now close to the pivot point for US interest rates. I think that the US Fed may just about get away with another rate rise or two if they are lucky which means that we may see interest rates peak at around 3% stateside but elsewhere in the world, interest rates will barely budge much above 1 or 1.5%. A recession or slow down within the next few years is almost inevitable and at this point both Europe and the UK are in a deep hole – their central banks won’t have enough flexibility in terms of interest rates whilst their balance sheets will also be mightily extended, even after the recent tightening.
In the meantime, I’m inclined to agree with Cross Border Capital that the odds must be growing now for a major policy easing in 2019, with central banks working alongside the PBoC as the main catalyst for liquidity. According to Cross Border “the US Fed is likely to follow given the scale of tightness in domestic and Global Liquidity and this must involve greater liquidity injections, rather than simple interest rate cuts. We have no view whether this takes the formal shape of an explicit ‘QE4’ policy or if it involves an unannounced increase in the size of the Fed’s balance sheet. Whichever, the immediate implications will be a yield curve steepening and ultimately a weaker US dollar. Financial shares and Emerging Markets may prove the main beneficiaries”.