Central bankers worry about "liquidity" as they start draining the cash mountain they have printed
November 6, 2017
During and post Global Financial Crisis central banks in USA, Europe, UK, Japan printed an unprecedented amount of cash trying to "heal" the global economic. This money printing was quaintly called quantitative easing and the magnitude of the money printing was reflected by the growth in central bank balance sheets.
Extreme monetary easing appears to have worked. The risk now, however, is that central bankers will not be able to withdraw without prompting a crisis.
Mr Powell (the new US Fed chair) has great interest in banking regulation and in the plumbing of the financial system, and he shares the concern of many in the market with liquidity. Talking to the FT last year, he said that most of the time in most markets, “liquidity is OK. But it may be more fragile, and more prone to disappearing in stress situations.” And he also made clear: “There hasn’t been a liquidity-related incident that has had a significant effect on the real economy. That doesn’t mean it won’t happen.”That is exactly the fear of many in the market. The immensity of central banks’ rescue operations left money coursing the financial system, which has also helped to cement a change in the concept of what liquidity means.
Over the next few years, the liquidity sloshing through those pipes must be withdrawn if central banks want to avoid a global overheating. The reason the BoE and the ECB seem so anxious to downplay the significance of what they are doing, as they start to withdraw that liquidity, is that they are terrified of causing an accident as liquidity dries up. The anxiety over liquidity also explains why those who look at financial markets tend to worry far more about the future than those who look at a real economy, in which all the main motors for growth - China, the eurozone and the US - are looking robust.
The risk is that central bankers will not be able to withdraw without prompting a crisis.
Fixed-income investors are acutely worried about the effect of less monetary easing.
Bob Michele, a bond fund veteran, is more worried than he has ever been. The head of global fixed income at JPMorgan Asset Management, the US fund house, has spent almost four decades investing in bonds. The 57-year-old, who oversees a $432bn pot of fixed-income assets, is gearing up for the most demanding period of his career.
Over the next two years, central banks across the world are expected to move away from the decade-long practice of pumping money directly into the financial system in an attempt to kick-start stalling economies. This process, known as quantitative easing, involves central banks printing new money and using it to buy bonds, pushing up fixed-income prices in the process. Now central banks including the US Federal Reserve, the European Central Bank and the Bank of Japan, which have collectively amassed $13tn worth of bonds on their balance sheets, are showing signs of a shift in policy. The Federal Reserve said in June that it would gradually begin selling some of its gigantic bond portfolio. The Fed has also slowly started raising interest rates, which typically causes bond prices to fall.
Mr Michele says: “Right now, central banks are printing money at a rate of around $1.5tn per year. That is a lot of money going into bonds. By this time next year, we think this will turn negative. “That will be a huge difference. What happens between now and then is the big question for investors to resolve. As long as money is being printed and prices are going up, you want to be involved. But you also want to be able to get out quickly.
Jay Bowen, president and chief investment officer of Bowen, Hanes, the asset manager that runs the Tampa firefighters’ and police officers’ pension fund in the US, adds: “We are on the edge of a co-ordinated global rate-hiking cycle. We have had a major tailwind over the past eight years in terms of very favourable liquidity conditions. These central banks have been a major player on the fixed-income side. “As [interest rate changes] start to go the other way, the liquidity is not going to be as favourable.” Investors fear heightened volatility, falling bond prices and even a bond market crash as central banks change course.
The ‘illusion of liquidity’
A lack of liquidity in bond markets was one of the biggest worries for investors and regulators in 2015, but by last year many asset managers had shrugged off these concerns. Now liquidity is back on the agenda. Earlier this month, the Bank of England published a study on market liquidity, which examined how asset managers and other non-banks could cause problems in bond markets. The central bank ran a “stress simulation” and found that under severe conditions, there could be a run on bond funds that causes a material increase in spreads in the corporate bond market. At worst, the BoE warned there could be “corporate bond market dislocation, threatening the stability of financial markets”.
I'm busy working on my blog posts. Watch this space!