Imminent liquidity squeeze or just prudent money management ?
Head of Macro Analysis
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.
Latest Market Insights
Quarterly Outlook Q3 2022: The Runaway Train
- Central banks' attempts to kill inflation is a paradigm shift, which could end in a deep recession.
Tangible assets and profitable growth are the winnersWith US equities officially in a bear market, the big question is where and when is the bottom in the current drawdown?
Understanding the lack of investment appetite among oil majorsThe everything rally seen in recent quarters has become more uneven, as its strength is driven by commodities in short supply.
The pressure is on as the wind leaves the sailsWith cryptocurrencies in sharp decline, are we entering a crypto winter or is the bear market a healthy clean-up of the crypto space?
Why the Fed can never catch up and what turns the US dollar lower?Many other central banks are set to eventually outpace the Fed in hiking rates, taking their real interest rates to levels higher than the Fed will achieve.
Bank of Japan: Swimming against the tideThe Japanese economy has gone from the age of deflation to rapidly rising prices in no time, leaving the Bank of Japan in a pickle.
Green transformation detour and bear market hibernationWith the impending risk of global econonomic derailment, we share the five things investors need to consider in this new half year.
Crisis redux for the eurozone?Whether there's going to be a recession in Europe or not, the path towards a stable economy will be agonizing.
Technical Outlook: Gold, Oil and a remarkable multi-decade perspective on EquitiesThe Nasdaq bubble pattern, USDJPY resistance, crude oil uptrend losing steam and the technical outlook for USD.
China: the train of new development paradigm left the station two years agoChina is transiting to a new development paradigm, as they are hit by deteriorating terms of trade, a slower global economy and an uncertain future while continuing attempts to contain the pandemic.