A widespread anxiety about liquidity co-exists with trillions of euros pumped into the markets by central banks. Daniel Ben-Ami explores the paradox
Will liquidity dry up in 2016? It may not be a high profile public debate but it is a question preoccupying many asset managers and international financial institutions at present. For the time being, it seems to have replaced volatility as a primary concern for many investors. It is also a topic that pension funds would do well to consider.
At a glance
• There are widespread concerns about the possibility of liquidity drying up in the financial markets.
• It is necessary to make a key distinction between funding liquidity and market liquidity.
• Tougher financial regulation seems to have played a key role in squeezing liquidity in recent years.
• Others also point to substantial structural changes within the financial markets as a reason for bouts of liquidity scarcity.
At first sight, it is hard to believe how such a scenario is even possible. Central banks have pumped trillions of euros into the world economy since the advent of the global financial crisis in 2008. With so much liquid capital sloshing around the financial markets it is difficult to conceive how liquidity could dry up.
Yet there are certainly signs of disruptions to liquidity in many markets. Much of the concern is focused on emerging economy bond markets but it goes further than that. One of the most high-profile episodes was the ‘taper tantrum’ in mid-2013 when Ben Bernanke, then chairman of the US Federal Reserve, merely raised the possibility that quantitative easing (QE) could be rolled back. Talk then was of the ‘fragile five’ – Brazil, India, Indonesia, South Africa and Turkey – which all had large current account deficits. Their currencies weakened, stock markets plummeted and bond yields surged. US bond yields also rose sharply in the aftermath.
Not that all the attention should be focused on emerging markets. Even German Bunds – one of a select group of government bonds to retain a AAA rating – have suffered problems with liquidity over the past year. When yields spiked in April it became harder to make trades, particularly in the futures markets.
The International Monetary Fund (IMF) has also made public its concerns about disruptions to liquidity. In the last few editions of its Global Financial Stability Report, its twice-yearly scorecard on the state of the financial markets, it has devoted significant space to the issue. It was also a topic of conversation at the annual meeting of the IMF and World Bank in Lima, Peru, in October. No doubt the discussions behind closed doors were more frank than the guarded public pronouncements.
Certainly the authorities have tried to play down these fears. William Dudley, the president of the New York Fed, gave a speech in September that was explicitly aimed at playing down these fears. He argued that the evidence that liquidity has diminished markedly is mixed and it is not clear, as some have alleged, that regulation is the primary driver. Dudley also emphasised the importance of focusing on the robustness of the financial system. The Bank of England has also published a blog post which was designed to assuage fears about falling liquidity in the corporate bond market in particular.
This article will attempt to gauge the extent to which liquidity poses a problem for the financial markets. It will focus particularly on what could be called the liquidity paradox: the peculiar combination of an ample supply of liquidity from central banks with apparent shortages in the market. It is a topic that is likely to prove a significant concern over the coming year.
A useful starting point for the investigation is to consider the meaning of liquidity. This is not sufficient to resolve the fundamental questions involved but it is necessary to eliminate common misconceptions. As Joachim Fels, a global economic adviser to Pimco, says: “Some of the confusion comes from the fact that people use the same word for very different concepts.”
It quickly becomes apparent that the term ‘liquidity’ is a deeply ambiguous concept. It refers not to one thing but at least two and arguably more. The names given to these different forms of liquidity also vary. There is, therefore, enormous scope to argue at cross purposes if the different concepts are not clarified.
On the one hand, there is market liquidity or what could also be called micro liquidity. This refers to the ease with which an asset can be bought and sold. So in a highly liquid market it would be easy to buy and sell assets, whereas in an illiquid one it would be difficult. Such matters are, of course, a central concern for market traders but they have implications for fund managers too. For example, it can make it harder for asset managers to either build up or exit large positions in particular assets. It is in the market arena that the current concerns about liquidity are focused.
Market liquidity is often measured by the bid-ask spread (also known as bid-offer spread) on an asset. In a highly liquid market, such spreads should be narrow – whereas, if there are problems, such spreads would be expected to widen.
Figure 1 illustrates this trend in relation to US Treasuries. The spread widens particularly in the midst of the 2008-09 financial crisis before falling back. It has also been on a broadly upward trend over the past year. A similar graph of euro-zone sovereign bonds would show Italian and French spreads spiking in 2011, with Spanish debt spiking in early 2012.
Although such graphs are useful, they are not infallible guides to the state of liquidity. It is possible for liquidity to suddenly dry up, or ‘gap’, from what appears to be a relatively easy state. For example, James Wood-Collins, the CEO of Record Currency Management, says: “Emerging market currency has long had more of a propensity to gap on unexpected news.” He goes on to explain how this trend has exacerbated recently. “Historically we didn’t see much gapping in developed market currencies but we’ve seen on four or five occasions this year when we have seen that,” he says. The sudden surge in the Swiss franc on 15 January when the Swiss National Bank removed the peg with the euro was a prime example. There can also be anxiety about the possibility of liquidity drying up which is not fully reflected in bid-ask spreads.
The other main form of liquidity is often referred to as funding or macro liquidity. It essentially refers to the amount of liquid capital circulating in the financial markets. This is the pool to which the surplus liquidity provided by central banks contributes.
This semantic distinction between market liquidity and funding liquidity helps clarify matters to a degree. It should be clear that market liquidity is the subject of concern, whereas funding liquidity, at least on the face of it, is ample.
However, this distinction, while useful, does not resolve the matter. It still begs questions such as why market liquidity should apparently be under threat when funding liquidity is so high. More fundamentally, there are questions over what impact expansionary monetary policy has on the markets and whether its effect is diminishing over time.
Many experts argue that there is no necessary relationship between market liquidity and funding liquidity. Although they are known by the same name, there is no direct connection between them. Salman Ahmed, the chief strategist at Lombard Odier Investment Managers, says: “There is no direct link, theoretical or conceptual, between these two.”
Pimco’s Joachim Fels points out that the two can move in different directions. “You can imagine a situation where you have a high market liquidity in the sense that it’s very easy to buy and sell assets,” he says. “At the same time, you could be in an environment where central banks are pursuing a tight monetary policy with high interest rates.” That, of course, is the opposite scenario to what exists at present where central bank liquidity seems high and market liquidity is relatively low.
The most common explanation for the recent propensity of the markets to liquidity shocks is the tightening of regulation since the 2008-09 financial crisis. The main focus is the banking sector where the regulatory authorities have made a concerted effort to ensure the banks take a more risk-averse stance. David Riley, the head of credit strategy at BlueBay Asset Management, says: “That regulatory response has significantly reduced the risk appetite that banks have and their ability to provide liquidity into the markets.” However, changes to the regulatory regime for insurers and mutual funds have also had an impact (see QE can work if conducted with the right logic).
Of course, the negative impact of regulation in this respect immediately raises a dilemma. While the central banks are trying to lubricate the markets, many financial regulators are, in effect, doing the opposite. “QE is meant to incentivise lending, whereas the new regulatory system is doing the reverse,” says Ahmed. It does not necessarily follow that tighter regulation should be resisted but it does illustrate the policy challenges faced by the authorities.
However, although regulation is widely seen as important, many do not view it as the whole story. There is a variety of explanations on why greater funding liquidity is not being translated into higher market liquidity.
For Francesco Sandrini, the head of multi asset securities solutions at Pioneer Investments, the answer lies in an imbalance between the supply and demand for debt. QE and similar measures have pumped huge amounts of liquidity into the financial markets but this is offset by a growing demand for debt among governments themselves. “The decrease of leverage in financial sector is more than compensated by increase in debt in the public sector,” he says.
To make this argument, he points out that, contrary to the public perception, the total amount of debt worldwide has continued to increase since the financial crisis of 2008-09. However, over that time its form has changed. With state bail-outs of financial institutions, the level of financial debt has diminished but public debt has increased.
This shift, Sandrini argues, has affected the money velocity. That is, in effect, the speed at which money is transmitted from central banks to the real economy. Since the financial crisis, and the advent of extraordinary monetary policy, this rate has slowed significantly (figure 2).
Fels emphasises, instead, the money multiplier (figure 3). This is a measure of the effectiveness of a given amount of central bank intervention.
Fels points out that asset prices were relatively low when central banks first started engaging in QE. But over time, as asset prices have risen, it has become necessary for central banks to spend more to have the same effect as before. “The first round of QE by the Fed was so successful because asset prices were rock-bottom,” he says. “Any given amount of QE today probably has a smaller impact on asset prices than it would have had three, four, five years ago.”
For Fels, that is not an argument against QE. Although its effect is diminishing, it is not zero, let alone negative. In his view, the answer is for central banks to inject even more liquidity into the system.
Perhaps the most radical critique comes from Michael Howell, the founder of Cross-Border Capital, a consultancy established in 1996 with the specific goal of monitoring global capital flows. In his view, the markets have largely failed to recognise a fundamental shift in the nature of financial intermediation over the years.
In the traditional textbook model, central banks provide reserves to the system which are then taken up by commercial banks. In turn, the commercial banks lend to industrial and other enterprises.
However, Howell argues, the situation has shifted fundamentally as many non-financial companies are awash with cash. Therefore, they are using their spare liquidity in other ways, such as buying back shares or engaging in mergers and acquisitions, rather than depositing their money in banks.
“The polarity of the financial system has reversed,” he says. “Industrial corporations are no longer borrowers from banks – they are effectively lenders into the system.”
As a result, banks no longer play their traditional role. “They have been disintermediated out of the system,” he says.
Howell argues that three elements have replaced the traditional role of bank reserves and loans. First, are new suppliers of funds. These include QE from central banks and money direct from corporates.
Second, the stock of collateral available in the system. For Howell the supply and demand for collateral plays a key role in determining the extend of liquidity in the financial system.
Finally, there is the collateral haircut. That is an adjustment to the market value of collateral designed to reflect the risk of not realising the quoted market value of securities.
In Howell’s view, several factors are acting to reduce liquidity in this new model financial system. These include threats to corporate earnings, the prospect of a Fed rate rise and a decline in the available pool of Treasuries.
‘QE can work if conducted with the right logic’
Professor Hans-Werner Sinn is the president of the IFO Institute in Munich and one of Germany’s most prominent economists. His latest book, Der Euro: Von der Friedensidee zum Zankapfel (The Euro: From Peace Project to Bone of Contention), has just been published by Hanser. Daniel Ben-Ami quizzed him about the pros and cons of quantitative easing at this year’s Uhlenbruch conference in Zurich
Q: What do you see as the impact of quantitative easing (QE) on the US?
QE has rescued lots of banks. It has rescued some economies because lots of liquidity was made available for investment in old and new assets. House prices have recovered and unemployment has been reduced enormously. The dollar also devalued after QE, which also gave a boost to the American economy. So, in principle, QE worked. As [former US Federal Reserve chair Ben] Bernanke said, we don’t know why it worked, but it worked.
It also worked in Britain. But it didn’t work in Japan – it did lead to a devaluation of the yen but the economy didn’t really get going. So Abenomics was a failure.
The question is what will happen with European QE? In theory, I think it’s good for the economy because through a devaluation it will inflate the euro-zone and allow southern Europe to stay behind and let Germany inflate away. That way, southern Europe will regain competitiveness and reduce some of its real debt. However, for regaining competitiveness, southern Europe has to stop taking Keynesian drugs. This, I think, is the economic rationale behind QE, which I endorse.
The point is, though, until now, we haven’t seen much of an increase in inflation in Germany. We have seen an increase in the core inflation rate for Europe, on average, but a symmetric increase in inflation everywhere is useless because we have a flexible exchange rate with the non-euro countries. What the euro-zone needs is a differential inflation in the north, while the south stays behind. It’s not yet clear whether this will be happening to a sufficient extent.
Q: Do you see any downside to QE?
The downside is that it’s possibly creating a bubble, or preventing the bursting of one, by keeping asset prices high. It’s delaying the necessary bankruptcies in the banking sector. The ECB [European Central Bank] seems to try to delay these bankruptcies until the banking union allows for a socialisation of the losses. On the other hand, differential inflation is the only way out for the southern European countries.
Q: How can worries about liquidity drying up coincide with central banks pumping large amounts into the economy?
The problem is that firms in the real economy don’t have easy access to credit finance. given the fragile state of their respective economies. The ECB hopes that by buying government bonds to increase liquidity it will lead to more bank lending to companies but this is unlikely to succeed.
If the ECB wants to improve the financing condition of companies it should not buy government bonds but corporate bonds or ABS [asset backed security] paper which is created out of credit claims of banks on private companies.
Q: So you think it’s the way that the ECB is conducting QE that is the problem?
Yes, it’s a circumvention. If I want you to have easy finance I should give you a credit, rather than giving it to a rival or your neighbour. That’s what the ECB does by buying government bonds. It allows governments to borrow more easily and hopes that the private sector can therefore also borrow more easily. That’s a logic which is not easily understandable.
Under this system, QE can also mean buying Treasuries from the financial system. Ironically, such action can mean taking liquidity from the financial system before giving it back again. “A lot of the time the central banks’ QE is a zero-sum game,” says Howell. “They are taking with one hand and giving with the other”. If he is right, it goes a long way to explaining why QE is having a diminishing effect.
“Do not confuse low interest rates with easy money”
Before drawing to a close, it should be noted that there are some who even reject the premise that central bank liquidity is plentiful. For example, Chen Zhao, co-director of Global Macro Research at Brandywine Global, says that, despite appearances, US monetary policy is tight at present. In his view, the strength of the dollar, in effect, amounts to a monetary tightening. “Do not confuse low interest rates with easy money,” he says.
It should be clear, then, that central banks can have a substantial impact on asset prices. There is also a reasonable argument, accepted by many, that they have a significant influence on market liquidity.
Ironically, the impact of regulatory action can work in the opposite direction. It is widely accepted that the trend towards the stricter regulation of financial institutions has played a significant role in tightening liquidity at times.
Central banks have played their role in playing down the threat of liquidity drying up. In their view the threat is exaggerated. But this view, while important to consider, should be treated with a degree of scepticism as one of their roles is to calm the markets.
For asset managers themselves there are some things they can do to mitigate the impact of a liquidity shock. Demanding a higher compensation for illiquid assets is one obvious step. Placing greater emphasis on credit quality is another. In any event, long-term investors should be less vulnerable than short-term ones.
Ultimately, though, the authorities may have to play an active role in resolving any difficulties. The authorities are no doubt well-intentioned but their actions seem to be pushing the markets in contradictory directions at present.
The topic will be one to watch closely in 2016.
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