Tightening Financial Conditions May Expose Untested Markets
Equity analyst Barrington Pitt Miller explains how a vulnerable market infrastructure may lead to a liquidity crunch with dire consequences in key markets.
- Markets are not sufficiently accounting for significant market liquidity given that the post-crisis infrastructure expected to ensure smooth functioning has yet to be truly tested.
- Magnifying this liquidity risk is the global quantitative tightening expected for this year as major central banks are on track to reduce their balance sheets.
- We believe the offshore U.S. dollar market may be especially vulnerable, given their lack of natural dollar-funding base and the limitations placed on U.S.-domiciled banks that have previously stepped in to meet any funding shortfalls.
Recent market volatility illustrates that investors are processing an array of risks. Among these are shrinking central bank balance sheets, uncertainty surrounding interest rate levels and potentially slower global growth brought on, in part, by the ongoing U.S.-China trade dispute, a potential endgame for Brexit and a weakening eurozone economy. While these issues have garnered significant attention recently, we believe that an underappreciated risk to the economy that has not received sufficient scrutiny is an untested market facilitation structure.
This matters as the shift from quantitative easing (QE) to quantitative tightening (QT) has entered a second phase: the absolute reduction of the combined balance sheets of the four major central banks. The drainage of dollars from the system, in our view, has already started to expose structural market vulnerabilities, which in turn could leach into the real economy. Evidence of this strain is reflected in recent comments by Federal Reserve (Fed) Chairman Jerome Powell, in which he seemed to backpedal from his December statement on the central bank’s balance sheet reduction: “But, I’ll say again, if we came to the view that the balance sheet normalization … was part of the problem, we wouldn’t hesitate to make a change.” In recognizing that this program is a source of tightening – in addition to rate hikes – he hinted that the path forward for asset reinvestment is not set in stone.
Exhibit 1: Stock Market May Portend a Weaker Economy Ahead
While many economic indicators remain positive, a pronounced slide in equities, such as what was experienced late autumn, have tended to lead periods of slowing growth.
Not Just Interest Rates
In recent years the global economy has had the tailwinds of favorable financial conditions, despite the Fed raising short rates. Four principal determinants of financial conditions are short- and long-term rates, the U.S. dollar and financial markets. Even with the Fed having raised short-term rates and begun reducing its balance sheet, conditions remained favorable, in part due to rallying financial markets and still-bulging central bank balance sheets in Europe, the UK and Japan.
One reason for last autumn’s market volatility was the realization that financial conditions were on the cusp of materially tightening. At that time, the concern was the sharp rise on longer-dated U.S. rates. While U.S. rates have come off their autumn highs, conditions still face tightening given the expectation for the Bank of England the European Central Bank to eventually reduce their holdings. When assessing financial market health, we believe it is necessary to examine the underlying market structure with the aim of identifying any potential vulnerabilities that may be unearthed in periods of stress. It is here where we believe significant risks exist, not only for financial assets but also the broader economy. The linkage between financial markets and the real economy is evident in the Fed using market mechanisms – namely, interest rates and QT – to influence the pace of growth. This linkage has never been stronger, and in our view, perhaps never been more fraught with risk. We need only look to the autumn’s violent moves associated with a modest uptick in long rates for an example.
Debt Market Mismatch
Our chief concern is a significantly different market facilitation structure than what existed prior to the Global Financial Crisis (GFC). Within debt markets, the issue is sheer size; nonfinancial corporate debt has skyrocketed while the traditional role of banks facilitating market functioning has been greatly curtailed by increased capital requirements.
Furthermore, the quality of this debt is poorer than prior to the GFC, given the rise in issuance by lower-quality companies. This is perhaps most pronounced by the rise of BBB – the lowest rating to maintain an investment grade – new issuance. The technical risk of forced selling by investors mandated to hold investment-grade credits due to large-scale downgrades in the event of a slowing economy would likely overwhelm the high-yield segment of the market. The ensuing dislocations caused by supply-demand imbalances could result in a severe downdraft in pricing as the gap between sellers and (fewer) buyers becomes digital rather than incremental.
Exhibit 2: Credit to the Non-Financial Sector as % of Global Gross Domestic Product
Corporate debt has risen over the past decade, while at the same time, the number of intermediaries that typically ensure smooth market functioning has been dramatically reduced.
The Pivotal Role of the Offshore Dollar Market
Another potential source of risk lies within the offshore U.S. dollar market. The dollar is often called the lubricant of the global economy and any malfunction in the flow of the greenback could potentially seize entire segments of global financial markets and the economy. As with corporate debt, the composition of the dollar swap market has been dramatically altered since the GFC. The dollar intermediation function of the large U.S. banks has been regulated away, not only by stricter liquidity and leverage requirements, but also more rigorous anti-money laundering rules.
Banks comprise nearly half of the offshore dollar market, and of that share, more than four-fifths are domiciled abroad. For many, this can mean they do not have a natural base of dollar deposits, which at the margin can drive them toward overnight dollar markets to meet operational needs and liquidity requirements. When liquidity becomes strained, U.S. banks have historically stepped into the void, but that is increasingly difficult when the Fed is precisely draining reserves, evidenced by a dramatic spike in overnight rates toward the end of 2018.
Exhibit 3: Spread between 3-Month USD LIBOR and 3-Month Overnight Indexed Swap
Often interpreted as a gauge of stress among banks and other actors in the overnight lending market, the LIBOR-OIS spread has widened since last autumn.
Just as domestic banks met their foreign peers’ dollar-borrowing needs in search of an arbitrage opportunity, nontraditional actors now do the same. Yet the hedge funds and other players that now populate this market have not been tested in times of stress. The possibility of a market dominated by “fair weather friends” is troubling. This possibility is what Mr. Powell alluded to when speaking of the “liquidity illusion.”
The Known Unknown
We do believe that financial markets can determine the macro environment. In fact, we consider it likely that it will, given tightening financial conditions on the back of QT and subsequent dollar shortfalls. Exacerbating this is an untested market structure potentially turning a liquidity hiccup into a fierce market downdraft, which could have a more profound impact on the global economy than a marginal change to short-term policy rates.
And while Mr. Powell briefly shined a spotlight on this “liquidity illusion,” we do not believe there has been sufficient focus by the Fed on the intersection of QT, market liquidity and market structures, which could have a more pernicious impact if met in tandem.
Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.
LIBOR (London Interbank Offered Rate) is a short-term interest rate that banks offer one another and generally represents current cash rates.