Large-scale asset purchases by major central banks has added to the abundance of liquidity in markets, however the tide is now turning in the opposite direction. As balance sheet normalization accelerates, it seems likely that liquidity issues could accelerate too.
One of the key risks to markets that I’ve been discussing for more than a year is balance sheet normalization. I have argued — and continue to argue — that quantitative easing was a big experiment, and so unwinding it is an experiment in and of itself. Now that balance sheet normalization has been in force for more than half a year, we are seeing its effects. And one key effect is on liquidity.
The three phases of the US Federal Reserve’s (Fed) quantitative easing created significant liquidity in US markets as well as global markets. That was by design; it was the dramatic tool needed to “lubricate” markets and the economy and help them recover after the global financial crisis. And large-scale asset purchases by other central banks including the Bank of England (BOE), the Bank of Japan (BOJ) and the European Central Bank (ECB) added to the abundance of liquidity in markets for nearly a decade. But the tide is now turning in the opposite direction. The Fed’s balance sheet normalization has been accelerating at a significant clip. The BOE has finished its latest round of quantitative easing, and in June announced it could begin to sell off the assets on its balance sheet earlier than previously thought. The ECB has been tapering its purchases and expects to end them by December. That will leave the BOJ as the last major central bank adding to its balance sheet in 2019 — and in testimony to the Japanese parliament several months ago, BOJ Governor Haruhiko Kuroda said that there are internal discussions occurring on how to begin to withdraw from the BOJ’s bond buying program.
Back in early June, the Reserve Bank of India Governor Urjit Patel wrote an op-ed piece in The Financial Times in which he sounded an alarm about global liquidity, explaining that the combination of balance sheet normalization plus greater issuance of US government debt (because the US is running larger deficits) has created a liquidity draw: “Dollar funding has evaporated, notably from sovereign debt markets. Emerging markets have witnessed a sharp reversal of foreign capital flows over the past six weeks, often exceeding $5 billion a week. As a result, emerging market bonds and currencies have fallen in value.” In other words, that big sucking sound you’re hearing is the US vacuuming up dollars.
It’s clear that emerging markets have been experiencing liquidity issues, just as Patel noted. However, the liquidity problem is not just isolated to emerging markets.
Liquidity is defined by Investopedia as the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price. And market liquidity is defined as “the extent to which a market, such as a country's stock market or a city's real estate market, allows assets to be bought and sold at stable prices.”
Based on the simple definition above, signs of lower liquidity have been appearing in other asset classes given that we have been seeing less stability in asset prices. For example, the rapid stock sell-off in February suggests less liquidity in the stock market.
Of course, there are other forces at work contributing to lower liquidity. For example, the situation is ironically being exacerbated by the Dodd-Frank Act, which was passed in the US in 2010. That’s because one of the requirements of Dodd-Frank is that banks must hold more of their assets in cash, which means they must hold less in marketable securities. Lower ownership of marketable securities means banks’ ability to serve as market makers is significantly curtailed. In addition, other forces such as high-frequency trading can exacerbate liquidity issues.
I must stress that we are only seeing warning signals of liquidity issues at this juncture — we are not in a danger zone, in my view. And there are many strong tailwinds for markets right now, including a positive earnings season, strong global growth (the US gross domestic product growth number for the second quarter was particularly impressive) and what appears to be a détente between the US and the European Union on tariff issues. However, I can’t ignore that, as balance sheet normalization accelerates, it seems likely to me that liquidity issues would accelerate as well.
This will be another important week for earnings and economic data, including the US jobs report, which will be released on Friday, Aug. 3. I expect a robust report with nonfarm payrolls in the area of 200,000.
Perhaps more importantly, we’ll be hearing from some major central banks this week.
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