Currently global liquidity is shrinking at an alarming rate, and the cause of this situation is not the collapse of the banking system like the 2007-2008 crisis, but the excessive tightening policies of central banks. For example, in the United States, although the Federal Reserve has only raised interest rates 9 times during this cycle, including balance sheet reduction and other operations, the effect is actually equivalent to 10 additional interest rate hikes. If the U.S. Federal Reserve and other major central banks do not change course, a global liquidity crisis will erupt, with disastrous consequences.
As we entered 2019, global liquidity shrank sharply, at a pace not seen since the financial crisis of 2007-2008. Investors once again began to painfully realize that low nominal interest rates do not necessarily mean that monetary conditions are truly loose.
In the context of tight liquidity, economic slowdown and even possible recession, risky assets have hit a wall one after another. The future is particularly bleak for economies, companies and industries that have muddled along over the past decade, dragging their feet on resolving their debt problems or even worsening them. For these highly indebted entities to refinance, high liquidity is an essential condition. If these debts cannot be rolled over any longer, systemic risks will erupt.
Chart 1 shows the scale of the recent contraction in global liquidity. The liquidity here refers to financing liquidity rather than market liquidity, although the two are actually closely related. Since the end of January 2018, global private sector liquidity has decreased by approximately US$3 trillion, about two-thirds of which occurred in developed countries. At the same time, global central bank liquidity has also decreased by US$1.1 trillion, with two-thirds of it occurring in developed countries. Emerging markets have experienced massive losses in foreign reserves. Taken together, global liquidity fell by more than $4 trillion to $124.1 trillion.
Comparing this 3% decrease with the “normal” trend of a 7% increase is even more shocking. In other words, after a brief recovery, global liquidity has once again fallen to about 25% below the long-term trend. The chart shows recent weekly actions by key central banks, with only the People's Bank of China still expanding its balance sheet. In U.S. dollar terms, global central bank funds have decreased at an annualized rate of nearly 10% in the past three months.
Objects of concern
When monitoring global liquidity, there are three channels that need to be paid close attention to, namely liquidity injected by the central bank, liquidity provided by the private sector, and cross-border flows of capital . The first refers to so-called quantitative easing and other central bank currency, repo and bond market operations. The second is all cash generated by the private sector, including credit. The third accounts for all net investments. Central bank liquidity and cross-border capital flows serve as primary liquidity, while banks and shadow banks provide secondary liquidity.
Although liquidity is closely related to interest rates, it is never a simple correspondence. This is especially obvious in the post-2008 era. A similar story holds true for the relationship between bank reserves, currency and liquidity.
The central bank has super influence in the non-regulated part of the financial system, where deposits are not the only source of financing. The most important thing here is the ability to refinance existing debt, and when the situation is exhausted, the central bank It is the last liquidity provider. In other words, in a crisis, liquidity is the most indispensable, so central bank intervention is also necessary. Given that liquidity supply is far more important for refinancing existing debt than for financing new projects, the size of central bank balance sheets is often much more important than the impact of interest rates themselves. Therefore, the relationship between interest rates and liquidity supply is almost never a simple correspondence. In the modern financial system, the central bank's decisive position in financing liquidity is increasingly consolidated, and it often directly affects market liquidity.
Chart 2 shows the dramatic expansion of the U.S. dollar money market since 1980, and the decisive role played by the Federal Reserve in the process. These markets have become increasingly important and, after the 2007-2008 crisis, have become almost as valuable as bank deposits. There are two types of players in the money market: traditional banks and shadow banks. The difference is that the former have deposits to rely on and are more flexible in lending.
Shadow banking is different. Its operation must rely on a more complex chain. For example, A lends money to B, and B lends money to C. In the process, they will provide other stored value instruments, such as asset-backed bonds. However, shadow banks are actually engaged in the repackaging and recycling of existing savings to a large extent, which means that they are often mainly related to wholesale financing in the brokerage chain and do not create much new lending. Shadow banking increases the flexibility of the traditional banking system, thereby pushing up credit multipliers.
The appetite for speculative loans is always good and seems to be unaffected no matter what the interest rates are. But if that were the case, the shadow banking system, which itself relies on bank credit, would not have ballooned in the run-up to the 2007-08 crisis. The fragility of this wholesale funding model based on short-term repos drives up systemic risk because it is a mortgage-based market that is extremely ahead of the normal cycle, and also has a negative impact on the operations of traditional banks.
Traditional economics fails to fully understand the risks in this area, because from its perspective, assets and debts always correspond, and the credit and debt of the entire system always balance to zero in the end, but they do not expect that the net number will remain unchanged. How much credit and debt will be derived within the system. In fact, the story of this process is simply climbing the highest stairs in the world, but traditional economics believes that no one will slip and fall!
The key role played by the central bank in the financing mechanism is also not fully understood, even by policymakers themselves. As a result, during the recent balance sheet reduction operation, which is to put the Treasury bonds and other collateral purchased during the quantitative easing period back into the market, the Fed's attitude was very arrogant and self-righteous, and it felt that this was a normal thing. However, in fact, quantitative tightening is likely to have an impact that is magnified several times in the modern financial system. For example, in Chart 3, we can see that the trend of the U.S. money market and the changes in the size of the Federal Reserve's balance sheet are actually very closely related. The recent reduction in the balance sheet has led to a chilling deterioration in U.S. money market conditions.
A whole new crisis
Thus, in 2007 and 2008, the trouble was mainly due to failures in the banking system, including overextended banks and the sudden collapse of shadow banks, but now But it is different. The situation is more similar to the credit crunch during the Asian financial crisis from 1997 to 1998. That is, all central banks, led by the Federal Reserve, have shrunk their liquidity supply, and cross-border capital flows have rapidly ebbed. The only difference is that today's financial markets are more interconnected and more global. Therefore, it is entirely possible that a new crisis will reproduce the Asian financial crisis-style sell-off, but the trouble will no longer be limited to one place. These are reflected in Chart 4, which divides changes in total credit into two parts, one is the credit multiplier represented by the black line, and the other is the monetary base represented by the orange line.
The most important thing during the 2007-2008 crisis was the decline in credit multipliers. In fact, the absolute decline had already begun in 2006. Subsequently, as the crisis evolved, the Fed's balance sheet expanded rapidly, which can be seen from the orange line in Chart 4. On the way to the 2007-2008 crisis, shadow banks have been lending based on new collateral, such as U.S. dollar deposits, and rehypothecating existing collateral, creating a "shadow monetary base"
< p>, as shown in Figure 5. Also included in the same chart are cross-border flows of capital targeting emerging markets, as these flows are likely to be primarily in the form of US dollar loans, which are likely to originate from the same offshore wholesale market. Therefore, it is not difficult to understand that the two are highly synchronized.Global Central Bank Currency Collapse
Unlike ten years ago, today’s monetary problems mainly lie in other parts, or directly speaking, the tightening of basic liquidity. Specifically, they include: tightening by the Federal Reserve, tightening by other major central banks such as the European Central Bank and the Bank of Japan, tightening by central banks in the "dollar area" such as emerging market countries, and legal suppression of the Eurodollar/offshore wholesale market.
Chart 6 shows the growth of the central bank's balance sheet, which is broken down into three parts, namely the Federal Reserve, non-US developed market central banks and emerging market central banks. The U.S. Federal Reserve increased its "reverse quantitative easing" limit to $50 billion per month, and the European Central Bank also stopped its quantitative easing operations from the end of the year. However, it can be seen that the current scale of liquidity shortage has exceeded both sum. As shown in Figure 7, most emerging market central banks are also like this, and it can be seen that, as in most times in the past, emerging market cycles largely depend on changes in their foreign reserves. This actually shows that the US Fed's tightening is causing additional negative chain reactions. In short, all three have played a role in the sharp reduction of global liquidity.
The fourth component of austerity is difficult to define precisely with numbers because data are so scarce. However, what is certain is that the U.S. federal authorities are aggressively attacking the offshore market, and they seem to be eager to regain control of U.S. dollar liquidity.
The Eurodollar market is beyond the reach of the Federal Reserve and the Treasury Department, and it played a major role in the shadow banking boom from 2007 to 2008. The United States is already pushing for SOFR to replace LIBOR as the new onshore money market rate, using the 2018 tax amnesty to encourage companies to withdraw offshore deposits, and eliminating the interest tax deduction for offshore banker loans, which will be significantly weakened. Attractiveness of the Eurodollar market. The effects of these measures are shown in Exhibit 8.
Other evidence of tightening
The scale of the current tightening can be seen from two statistics, one is the "real" term premium of the US ten-year Treasury bond, and the other is the G4 yield curve . Ten-year Treasury bonds are considered safe haven assets, and a low term premium means high global demand for these assets. Excluding the impact of inflation expectations, when the demand for safe assets is "normal", the real term premium should be around zero. When investors have strong demand for safety, the real term premium will be depressed, and when everyone is willing to change When you take more risk, it gets pushed higher. Therefore, this indicator has become an important reference for judging whether monetary conditions are too loose or tight.
Chart 9 shows the trend of the real term premium and federal funds. It can be seen that due to reverse quantitative easing, the real federal funds interest rate is actually closer to 5% instead of the 2.5% target. This is equivalent to the fact that during the current tightening cycle, the Fed has raised interest rates 20 times, instead of what everyone has seen. 9 times.
Chart 10 shows the global interest rate term structure shown by global liquidity and the G4 government bond yield curve. When liquidity tightens, investors will demand more safe assets, driving down their yields and term premiums. Currently, the government bond yield curves of several major economies are flattening, which illustrates the deterioration of the global liquidity environment. deterioration.
Conclusion
In 2019, there may be major loose changes in monetary policy at the global level. Currently, only China is easing, but given the tight liquidity situation in the United States and globally, it is expected that the Federal Reserve will likely follow suit, and not only cut interest rates, but also inject additional liquidity. It remains to be seen whether this will be the so-called fourth round of quantitative easing (QE4), and whether the Fed's balance sheet will expand again.