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Thirteen and a half years ago, at the end of 2008, the US FED kicked off on one of the most debated experiments in financial history: public sector quantitative easing. With policy rates at the zero-bound, injecting liquidity directly into the financial system through large scale asset purchases, the aim of the FED was to reliquefy the banking system thus enforcing a reversal of the extreme credit crunch that threatened the functioning of the economy. The central bank liquidity surge instantly sparked liquidity creation by the private sector. Indeed, the non-financial sector received a green light and debt capital markets kicked into higher gear, providing funding across credit sectors. Banks were brokering the credit starved corporate sector successfully. This blueprint inspired DM central banks over the following decade. Global liquidity got in a permanent state of excess. Over March 2020, as the global pandemic erupted, liquidity provisioning went in overdrive as, next to central banks going all-in, governments provided helicopter drops in the shape of several income supporting initiatives for households. In hindsight, central banks have been late to withdraw the liquidity added over the past 2 years. Yet, the effects of overstimulation represented by an overheating labour market next to out-of-control inflation as we leave the pandemic behind us, need to be addressed.
Eventually, as a synchronised monetary tightening cycle by EM (started over 2021) and DM (started over 2022) central banks is gaining pace, the risk of tumbling from liquidity pains into a liquidity crunch increases.
The question we have to ask ourselves is whether we have correctly assessed the impact of rising global liquidity pains that started to unfold in early 2022? What are the chances exactly that liquidity pains morph into a liquidity crunch? Because the moment we fall into a liquidity crunch, a credit crunch is not that far away. In order to do so, let’s briefly reflect on the indicators that impact global liquidity conditions.
First, the main indicator to measure global liquidity or the ease of financing is dependent on the level of short-term interest rates. Over 2021, EM economies pre-emptively kicked off a policy rate hiking cycle that continues till today. DM central banks followed over Q1 2022. Current market pricing sees DM and EM central banks reach terminal rates around the summer of 2023. Some EM markets show evidence of easing over 2023. For the FED & ECB, high-end estimates sit at 3.5% and 2% respectively. Rules based monetary policy (Taylor rule or deviations thereof) is not fit for purpose in a debt-laden global economic setting. Such rules, even based on defensive core inflation readings, still require policy rates to rise about 1.00% above the high-end estimates mentioned, towards 4.5% in US and 3.00% in Eurozone. Really? Yes, Taylor rule calculations give rise to such terminal rates putting in core inflation at target, leaving unemployment around current levels of 3.6% in the US and 6.8% in the eurozone. Even if markets price policy rate normalisation by the summer of 2023, it is still hard to predict how markets will behave when central banks do adjust with 50bp or 25bp increments.
The second indicator to assess liquidity conditions goes by asset valuations. These have adjusted brutally since the year started. The longer-term US ‘across the cycle’ intermediate rate estimate represented by US 5Y5Y forward rates reached about 3.00%. That is almost in line with the average level post Great Financial Crisis (GFC) of 2008. We observed a mean-reversion tendency in global equity markets mainly as a result of multiple contractions. Further compression in valuations will require earnings adjustments as margin pressures cannot be dealt with properly. Inflation remaining too high and difficult to offload onto customers or salary cost increases in order to retain talent, come to mind. The jury is still out here as a macro call is too complex. The advice is to do your homework that goes by classic, proper bottom-up analysis of balance sheet risk and cash flow yield resilience.
The third indicator that measures the global liquidity temperature comes via uncertainty indices. In the US we look at the VIX index for equities or the MOVE index for US Treasury bonds. With the VIX at 25, spot and priced around 28 over the last three months of 2022, we can posit that nervousness in equity markets has not settled at all. The longer-term average measures 20. Revisiting levels just above 10 requires high excess in liquidity conditions. Current readings show that liquidity conditions are not conducive of stable equity markets. The VIX expresses uncertainty next to risk appetite. Uncertainty remains high and risk appetite might only pick-up the moment we get closer to the terminal policy rate. Increasing risk appetite might be a theme of 2023. The MOVE index, or implied volatility estimate on 1-month Treasury options weighted across the 2, 5, 10 and 30-year US rate futures contracts, fluctuates around 100. The long-term mean of the MOVE index stands at 92. One can state that bond participants across the sell and buy-side have to get used to the current volatility environment. Indeed, most actors in bond markets need to adapt to an era that was common during the 90’s. On balance, we might state that, today, bond and credit markets exhibit higher adaptability to tighter liquidity conditions than is the case for equity markets.
The fourth and last indicator we discuss is represented by money supply, capital flows, international reserves, and (cross border) credit growth. Clearly money supply growth is under pressure as central banks rolling into a balance sheet run-off process. The FED started last week. The ECB will end active QE end of the month. As the public sector QE tapers off, it will be key that private sector credit growth takes over. Banks and corporates alike require the confidence to walk alone without the help of central banks doing the heavy lifting. Banks have tripled their capital buffers since the GFC. Bank regulators also pushed for honouring highly liquid ‘business as usual’ thresholds. Still, fact is that banks received lots of support in short-term funding as well as in the conduct of their disintermediation role to cater for long-term corporate funding. In Europe, without the support of attractive and unlimited Long-Term Refinancing Operations securing bank balance sheets well into the future, it stands to see how bank management teams uphold their risk appetite. Tracking bank credit growth rates across the EU and the US is a must. Early signals of comfort or stress can show up in such indicators.
On average, non-financial corporate balance sheets are healthy. Debt roll-over risk for IG credit is low today. Yet, nervousness across HY corporates is on the rise. With the lack of a ‘search for yield’ psychology we can expect higher dispersion in credit spreads across HY issuers. Over time, this might impact the BBB segment of the IG universe as the hiking cycle progresses.
At a sovereign level we notice that some EM countries run into funding stress. IMF lending facilities are required. Central bank currency swap lines have become a standing facility. The Chinese central bank is careful and provides more liquidity to its banking system with a close eye on regional liquidity conditions.
This fourth indicator is the one to watch as DM public liquidity providers (i.e., DM central banks) go off stage. Can banks and corporates prevent liquidity pains from turning into a liquidity crunch? Since the GFC, savings that got recycled by financial markets performed well. However, looking at fixed income sectors, almost all performance since the start of 2015 has been given back due to rising rates since Q4 2021. Luckily, balanced portfolio solutions still look back at decent annualised returns between 3.5% and 4.5%. Still, the damage over 2022 has been destabilising.
Global liquidity conditions are going through a severe test. Markets and financial actors are passing through an adjustment episode. This episode might run for another year before turbulences settle. Difficult to call. Execution risks are high as central banks dial back from excess towards ‘normal’ liquidity provisioning. The moment liquidity pains transform into a liquidity crunch, red alert will be given. Such events would quickly derail into credit pains and crunch conditions that are highly deflationary.