Head of Macroeconomic Research
Summary: The recent sell-off in emerging markets combined with higher real rates, stronger dollar and stocks turning red all around the world have been interpreted by many investors as the sign there is not enough liquidity added by the Federal Reserve. We examine in this article whether or not we are about to face a new liquidity squeeze, as it was the case in Q3 2019 for instance, and what could be the implications of higher financial stress in the coming months for investors.
In recent days, an anecdotal event has attracted a lot of attention in the market. Aethon United BR LP, a Texas-based natural gas company that was founded in 2016, was forced to postpone a $700 million high-yield bond sale that would have refinanced existing debt. The company refrained from making any comment, but many investors and analysts interpreted this event as the sign there is not enough liquidity added by the Federal Reserve into financial markets. It may sound paradoxical given the huge amount of liquidity provided over the past few months to offset the consequences of the pandemic, via various asset purchases programs. According to our in-house tracker, liquidity injections by the Federal Reserve represented a combined record of about 7.7 percentage points of global GDP over the second and third quarters of 2020. In contrast, over the same period, liquidity injections by the ECB only stand at 1 percentage point of global GDP and it is down at 0.7 percentage point of global GDP for the BoJ.
For policymakers and investors, a liquidity squeeze, which is characterized by difficulties to have access to money in the short term, is the worst-case scenario in a period of weak growth prospects and looming economic risks due to the pandemic. It could seriously jeopardize the recovery and cause distortions in the entire financial system. The last time a major liquidity squeeze has happened in the repo market, in September 2019, the Federal Reserve had to intervene for an unprecedented 10-month period to successfully tame volatile funding costs.
Are we nowadays on the bridge of a similar turmoil? It we look at the repo market, there is no difficulty to access to money in the short-term. Among all the things the Federal Reserve has to worry about, the repo market is clearly, and by large, no longer one of them. More important is the fact that the overall monetary conditions in the United States are still very expansionist. In order to assess current monetary conditions, we have built an index which is composed of seventeen variables reflecting exchange rates, interest rates, money growth but also unconventional measures. In details, it includes interbank rates, swap rates, FX indices, FX spot rate, monetary aggregates and assets held by the Federal Reserve. This is one way, among many others, to build such an index. In the present case, we have followed guidelines established by Wu and Xia in this excellent paper. As the below chart well represents, the overall monetary conditions in the United States are still largely expansionist, though less than during the 2008 crisis. Based on that, it would be mistaken to suggest there is a relationship between few isolated events on the high yield market, which is always more complicated to analyze due to the higher risk profile of companies which refinance there, and the access to overall liquidity in the short term. There is therefore certainly a better explanation to the recent fly to safe havens and the rise in real rates.
In our view, given current very accommodative overall monetary conditions and the absence of signs of financial stress in the short term borrowing markets (notably the widely watched repo market), we believe the recent events are not consistent with the risk of imminent liquidity squeeze. It rather reflects prudent money management from asset managers and asset owners putting money on the side or in safe assets to be prepared to face the risks associated with the upcoming U.S. presidential election. Many investors, rightly or not, are worried about the possibility of a contested election in case of irregularities. It could cause an institutional crisis and ultimately end up at the Supreme Court. The risk is real, and could obviously trigger a new market selloff, but we are not in the situation where we are about to face a wholesale carnage due to temporary credit freeze. At the moment, there is no rational reason to fear a liquidity squeeze.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
