Liquidity

Liquidity is likely to be a key factor determining the duration of the current bear market in risk assets.

Michael Howell, managing director at Cross Border Capital, is known as the godfather of liquidity, and in a recent interview, he sheds light on global liquidity.

The global financial markets and the economy are hyperresponsive to changes in liquidity

The Godfather of liquidity explained that the global economy is awash with debt, which currently amounts to approximately 300 trillion US dollars.

Moreover, the average lifespan or maturity of the debt is five years, which means 60 trillion US dollars of debt requires refinancing every year.

Why is liquidity beneficial for risk-on assets?

When central banks pump more liquidity into the financial system and the economy, that decreases systemic risks, the system is liquid, and entities can easily secure funding.

When businesses and investors can secure funding easily, that also means they move along the risk curve into higher-risk instruments. In other words, demand for safe assets and liquidity is low. 

So liquidity is good for risk asset prices less liquidity is negative for risk asset prices.

Who are the drivers of liquidity?

As mentioned above, central banks control a lot of liquidity through their monetary operations. So Quantitative easing QE or quantitative tightening QT, influences the size of their balance sheet and impacts liquidity.

QE means central banks are purchasing assets, thereby adding liquidity to the system. QT is the inverse of QE.

SO central banks influence liquidity by purchasing or selling assets through open market operations. Making special-purpose loans is another way of injecting liquidity.

Reducing or increasing the Fed fund rates also impacts liquidity.

The banking system, high street banks, also creates liquidity by granting loans and mortgages

Shadow banks that effectively do banking-type operations can also influence liquidity through exotic instruments. For example, shadow banks offer Repos, overnight lending to banks, and other money market instruments.

Corporations building large pools of cash also add to the liquidity pool. 

Cross-border investors are also another source of liquidity.

What is the implication of liquidity in a bear market?

Withdrawing liquidity is a big negative for assets price because, as explained above, it raises systemic risks.

When there is less liquidity demand for assets falls because buyers are less able to get credit or use savings to make transactions.

The Godfather of liquidity explained that normal monetary tightening would lead S&P down by about 15%.

If a recession plays out the correction could be typically a 30% reduction. In a banking crisis, we could see a 50% correction.

The financial system is a refinancing system, as explained above, 60 trillion dollars of debt requires refinanced every year. 

So the system needs liquidity, and central banks can not continue tightening when a system has so much debt, with the economy in a recession with a bear market in stocks.

When the Fed’s balance sheet shrinks, asset prices will also contract.

Declining liquidity will raise market volatility

Recently we experienced high volatility in the forex with the collapse of the yen and euro, soaring yields in the treasury market, and climbing commodity and oil prices all signify stress in the system. 

Increasing volatility leads to a vicious circle of liquidity contraction

When liquidity rises, investors find it more difficult to borrow against their collateral, which leads to less liquidity and more volatility. 

The godfather of liquidity believes we could be in the mature phase of the turbulent investment zone

In this zone, we see flattening yield curves, increased bond volatility, and outperformance from growth names like brands or utility stocks.

It is also a period where investors hold sizable cash positions, king dollar positions. 

The 15-20 month displacement of the economic cycle is the typical lead time for liquidity to proceed with business activity. 

The liquidity cycle moves through three phases

Calm is the first stage of the cycle where liquidity is above average and rising.

Then there is speculation which is a late-stage cycle when liquidity is above average but falling. The second phase of the liquidity cycle is turbulence when volatility becomes more of a problem. In the turbulence cycle, liquidity is below average and falling. 

The third phase of the liquidity cycle is a rebound, a new cycle beginning where liquidity is below average but rising.

What phase of the liquidity cycle are we?

Fixed income markets indicate we could be in the late turbulence zone.

The 2-year treasury gives the best heads up where the Fed fund rates are heading, according to bond king Jeff Gundlach.

Notice how the US2Y yields have been trending down over the past month.

So the bond market is telling the Fed no more rate hikes.

If this is correct, peak hawkishness, where liquidity tightening has peaked, could have been reached. In other words, we could be in or near the rebound cycle where smart money accumulates risk assets near price support levels.

The Fed pivots and the liquidity cycle reaches a trough when something breaks

Forty billion euros of European corporate bonds are in distress, and US mortgage lenders are going bankrupt. First Guaranty Mortgage files for chapter 11 bankruptcy, and Loan Depo fourth-largest lender in the US, which made 137 billion US dollars of loans, is circling the drain. 

Australian bank Volt collapses and has urged 6,000 customers to withdraw their funds.

Centric crypto lender files for bankruptcy. 

The system is at a systemic risk of collapsing and requires liquidity. Alternatively, game over.