This week I want to return to my regular peek into the world of economic and financial signals. My mission in these regular Last Call pieces is to investigate what we can divine from the numbers about what to invest in the next few years.
Last time I looked at the sometimes-opaque world of bank credit default swaps. This time I want to stick with banks but look more broadly at global liquidity and central banks in particular. Many institutional investors like to keep a close eye on macro trends in the global capital markets, specifically relating to liquidity. Put simply, if this vast pool of liquid cash dries up, chaos looms. If not, investors relax and keep buying risky stuff such as equities.
To understand how this global liquidity pump works, let's first take a diversion. To interest rates. We fetishize the direction of interest rates, especially those set by the US Federal Reserve. The Fed's latest prognostications even make it on the nightly news. We wait, with bated breath, on their deliberations.
But I would argue that we miss the real headline line numbers which lurk in the bowels of the US central bank's report. The numbers that I care about refer to the size and nature of its balance sheet. If you’re bored one afternoon, you can even see these numbers yourself here. By the way, if you want to see the UK version of this, head here.
You’ll see that the Federal Reserve's total assets have increased significantly from $270 billion on 8 August 2007 to $4.5 trillion on 14 January 2015. The important point is that the chart is currently showing a decline.
Quite right, most of you will say! These central bank balance sheets have been increasing the scope of their operations far too much and they now need to revert to normal practice.
The problem is that the world really has changed and it's not all the fault of the central banks. Over the last few decades, we’ve seen the rise of a new global money market in wholesale capital, worth trillions. This vast liquid, global market comprises all sorts of private sector credits including repos, commercial paper, foreign exchange swaps and bank bills. There are also vast pools of corporate treasury accounts looking for a safe home and a yield. This makes up the vast global pool of private sector liquidity.
Guess what keeps this pool liquid and safe? Yep, central bank operations. Central banks like the US Fed and our own Bank of England offer up their own balance sheets to help keep this market moving, partly through repos and reverse repos as well as reserves, and bond-buying programmes. These money market operations sit alongside cash in circulation and treasury bills.
Rather like a vast, planetary-scale water balloon, this system expands and contracts. Central banks and especially the US Fed would like to contract their balance sheet exposure to their private sector operations. And until a few weeks ago, that is exactly what they were doing.
A London-based research firm called CrossBorder Capital keeps a close eye on these trends – I’ll keep you updated on its regular reports sent to hedge funds. In particular it tracks these pools of liquidity, from both private and central banks, via an in-house liquidity index.
At the end of January its analysis suggested a drastic tightening in global liquidity as the central bank ‘lubrication’ machine started to slow down. In fact, a report from a few weeks ago observed that its proprietary global liquidity index had ‘skidded to 14.3 in January (‘normal’ range 0-100). Tight central bank policies are the driving force and a staggering near-80% of the world’s central banks are quantitatively tightening. This tightening is now impacting global economic activity, and looks to be a case of overtightening’.
The chart below gives us a graphical representation of these trends. As trends go, this is one heck of a warning sign of trouble ahead.
Source: CrossBorder Capital
This rams home what I think is the central message. Asset market booms – bull markets – tend to continue for one to two years after a liquidity cycle peak. By contrast, banking crises typically occur within one to two years of a liquidity cycle trough. And we are fast approaching a liquidity cycle trough.
If you haven’t already got the message, let me put it as plainly as possible. One of the reasons why equity and bond markets boom is that there’s plentiful liquidity i.e spare cash to invest. If this pool of private sector cash starts to diminish because central banks are tightening their balance sheets, we all see the impact.
Central banks start to sell their bonds, pushing down the price and pushing up the yield. Corporates start to get nervous, rein in spending, and economic growth slows down. At which point president Trump gets on to Twitter and threatens to fire the governor of the US Federal Reserve, which organisationally reacts by curbing its strategy of tightening its belt.
If central banks start buying financial assets again, from bonds through to helping the repo market, liquidity flows again and we’re all as happy as Sandy. Obviously, free-market types start to worry about the sheer monster-like scale of this multi-trillion-dollar balance sheet but most of the time their attention is, mistakenly in my view, fixated more on the size of public sector government deficits. They really need to be looking at those central bank balance sheets – plaster those numbers on the side of a building!
Three observations drop out of this exercise in liquidity rune reading. The first is that my guess is that central banks will start to slow down their tightening, coordinating a global effort to let their balance sheets breathe again and cross their fingers this will be enough.
I would wager – and CrossBorder have the numbers to back this up – that the Asian central banks will be first to the pump primes. Which might suggest a tactical reorientation towards risky Asian funds.
Next up, when the next recession comes the central banks will be in a hole (mixing the metaphors wildly here, what with holes, pumps and sloshing liquidity).
Their balance sheets will be huge, and about to grow even bigger. Interest rates won’t have risen by as much as they’d like – central banks typically like to cut rates by around 3% to 3.5% percentage points into a recession.
That means they’ll have to do all sorts of freakie deakie stuff. Albert Edwards, strategist at French investment bank Société Générale, reckons that when this grim day comes – as it must – ‘our “all-knowing” central bankers will pull any and every policy lever they have to hand and that in my view includes the Fed pursuing deeply negative interest rates’.
Edwards continues: ‘I do not believe the Fed wants to rush to cut Fed funds into negative territory, but the cost of not doing so will be very high if others are doing it (via a strong dollar). The Fed will be forced to participate as avoiding deflation will be the number one priority - not the profitability of the banking sector.
‘Investors should contemplate a brave new world of negative Fed funds, negative US 10-year and 30-year bond yields, 15% budget deficits and helicopter money.’
So, await with fear negative money, soaring bond prices and free money.
One last final point. Investing in bond funds, especially those with a more strategic focus (giving the manager the ability to play these big trends) might be rewarding again as rates fall in the next year or so, and balance sheets expand again. In a world drowning in debt, the smart money will stay in low yielding debt.
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