Over the past decade, the term “liquidity trap” has been used a lot in Western markets. Because central banks have funded the financial system so much, via quantitative easing, that it seems the glut was becoming ineffective.
This week, however, investors would be well advised to ponder another concept: a “liquidity hole” – or, perhaps more accurately, holes.
While the US Federal Reserve did not raise rates this week, Fed Chairman Jay Powell essentially promised that rate hikes would begin in March. More importantly, the Fed also released a weighty document pledging to reduce its balance sheet as well.
Taken together, this means investors could soon see something materialize in the markets that most have barely seen in the past decade (barring the first pandemic shock): a shortage of buyers for certain assets. compared to the offer.
“This [gap] will start in the bond markets, but then expand into other assets,” Greg Jensen, co-chief investment officer at Bridgewater hedge fund, tells me. “It will be painful for many investors as they have been extrapolating for the past decade [of liquidity gluts] in their wallets” – and are therefore unprepared for the holes.
How painful? An optimist might argue that any price shock will be modest. After all, by historical standards, the global financial system in general – and the US system in particular – is awash with liquidity.
That’s partly because the Fed doubled the size of its balance sheet to $9 billion during the pandemic, after having quadrupled in the previous decade. His counterparts in Japan, Europe and the UK were also hyperactive.
Meanwhile, credit creation in the private sector has also been hyperactive, causing the closely watched Goldman Sachs Financial Conditions Index to hit an all-time high of 97.73 at the end of 2021. This means that the funding has been super abundant.
Also, the numbers implied by the Fed’s tightening plans for 2022 don’t look huge compared to its balance sheet. The Fed is expected to buy $20 billion in US Treasuries and $15 billion in mortgage bonds in February.
Oxford Economics calculates that when the Fed stops these purchases and lets existing assets mature, it will result in an “effective reduction in Fed purchases of $90 billion in bonds each month – or $400 billion.” [reduction] in the second half of this year and $1 billion in 2023”. This would not bring the balance sheet back to its pre-pandemic level.
However, the key point for investors to remember is that the supply of government bonds continues to grow as Western governments grapple with their mountains of debt. And while the US government is expected to end its fiscal stimulus in 2022, its financing needs remain exorbitant.
So even a “simple” $90 billion monthly cut in Fed purchases could create jolts, especially since the Fed currently owns one-fifth of the inflation-linked bond market and has recently funded “up to 60-80% of all government borrowing needs” in recent years, according to Lawrence Goodman, director of the Center for Financial Stability.
Indeed, JPMorgan calculates that the net supply of government bonds “which [will] must be absorbed by the market [will] increase to $350 billion” in the second half of this year. It’s a big hole.
What’s more, market liquidity isn’t just a matter of raw monetary numbers, but also of psychology – and there are already signs that private sector investors are firing in their horns as the Fed plans to pull out. .
A telltale sign is the recent trend in bond and stock prices. Over the past two years, as Jensen notes, a decline in US stock prices — of the kind seen in late 2020 or 2018 — has gone hand in hand with a rise in bond prices. This suggests that investors reacted to the shocks by rotating their money between asset classes, not withdrawing it altogether.
But since the start of this year, bond and stock prices have fallen together. Meanwhile, there has been an even more dramatic rout in speculative asset classes, such as cryptocurrencies. Instead of portfolio turnover, we see signs of capital flight.
From a long-term perspective, this is a healthy development, given that a decade of ultra-accommodative policies has driven asset prices to staggeringly high levels, relative to real economic growth. Indeed, I would argue that the Fed should have started tightening a while ago.
But desirable or not, no one should ignore how risky this change is – and how difficult it is to model the market implications. No one knows what will happen when a central bank attempts to simultaneously raise rates and shrink its balance sheet, because it has never been done on this scale before.
Nor do we know how the tightening will play out in a world where so much of credit intermediation now happens through markets (and not through banks, as before) – and where wealth inequality, in partly due to high asset prices, “potentially blocks the transmission of monetary policy”. , as stated by Karen Petrou, a financier. We are in uncharted territory.
No wonder Powell admitted this week: “I don’t think it’s possible to say exactly how this [tightening] will go “. If anything, that’s an understatement. Investors should take note and pay attention to these liquidity holes.