Recent investor concerns over decreasing market depth across many fixed income segments reflect more serious downstream problems in funding markets.
These problems are now coming to a head, have four components which taken together combine to undermine the long-term supply of global liquidity.
They explain why our monthly GLI index measure is declining. Looking ahead, they warn that without either some relaxation of monetary policy or a deficit-financed fiscal policy, global liquidity is likely to stay depressed. Risk officers beware.
The CBC index of global liquidity (GLI) flows declined again in December 2015 to a weaker reading of 41.8 (range 0-100). Liquidity matters because periods when it is subpar are associated with ‘risk off’ periods in capital markets and weak economic activity over the following six-12 months.
Without these ‘sources’ of finance, economic activity cannot take place: the outlook is worryingly poor.
Sources of liquidity supply have been going through a revolution over the past decade to such an extent that the ‘polarity of the financial system’ has seemingly been reversed, making it harder to understand. Partly due to deregulation, which turned banks into investors and many investors into banks.
But much is explained by industrial corporations turning themselves into net suppliers of cash to markets, rather than borrowers, as better cost management boosted their gross cash flows and fewer investment opportunities reduced incentive for new capex. These cash flows largely by-passed traditional banks and went direct to wholesale money markets. But they are now slowing.
Wholesale money markets and shadow banks that operate in them are not reserve constrained. They create credit between one another by lending against collateral, subject to collateral ‘haircuts’ that control leverage. The availability of collateral and the size of haircuts, rather than the supply of reserves by the central banks, are what control shadow banks’ credit growth.
But new supplies of ‘good’ collateral or ‘safe assets’ are falling; the Fed’s Treasury holdings that drive QE are flat; the Fed’s reverse repos that drain liquidity are up and EM forex reserves which spread dollar credit internationally are down: the conclusion is that from every angle the pool of collateral and the components of base money are turning downwards.
The outlook for US dollar liquidity in the world economy therefore looks bleak.
The situations in Japan, China and Britain are similar and the only impetus for new liquidity is coming from rising ECB QE.
But the Eurozone is too small to bail out the world.
Ahead, the latest data warn that without either relaxation of monetary policy or a deficit-financed fiscal policy, global liquidity is likely to stay depressed for some time.
Either policy-makers must hastily reverse course and start to pump back more cash in a new ‘QE4’, or risk officers must start to plan for a low liquidity future.