Global markets were sent into a tailspin yesterday after the Federal Reserve held fire on interest rates amid fresh concerns over the Chinese economy and emerging markets. But market mavens should be paying attention to funding, rather than interest rates.
It’s frequently said and not always in jest, that the credit markets are smarter than the stock markets. Here it’s not about interest rates, banks’ reserves or even central banks. The issue for the credit and bond market is funding.
This was underscored by the 2008 crisis and nearly every subsequent wobble thereafter. It’s happening again now. Today, the main word on every bond manager’s lips is ‘liquidity’ and these concerns come back to the inadequate supply of funding, particularly dollar funding in global markets.
The Fed’s "off-on" interest rate decisions are less important than what it does with its balance sheet, i.e. quantitative easing.
Central banks have long ceased to be managers of banks’ reserves - rather they are one of many suppliers of funding. Their importance is that they can (and should) increase this funding when the larger pool of private sector supplies is draining down.
This is a trick the Fed missed in 2007/08. And it looks like it's getting it wrong again. The latest travails in China, including recent large capital outflows and the slide in the renminbi, are an ominous testimony to these funding shortages.
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Credit spreads are widening out and treasury yield curves flattening around the world: concerned investors are fobbed-off with excuses of ‘renewed deflation’ or the ‘weak shale oil patch’, but the causes are deeper and connected to deteriorating levels of funding. They may also be behind the Fed’s recent "insurance policy" of providing extra US dollar swap lines to European Central Banks (ECB).
The key issue is that the funding markets are increasingly pro-cyclical. Part dominated by the treasurers of industrial corporations with excess cash to invest, the US wholesale money markets are highly dependent of the profitability of US business.
Several profit warning, particularly from companies close to the skidding Chinese economy, suggest that US corporate cash flow is itself fast-slowing and with it will go funding capacity for the credit markets.
The chart below suggests that the fall-off in our index of US funding liquidity has lately been so rapid that, based on the subsequent movements in the New York Fed’s Empire State business survey shown alongside, the US economy could hit recession in 2016.
US policy-makers should be thinking about another round of quantitative easing, and not the next interest rate rise.