12 February 2016

Say goodbye to global liquidity… hello black hole


This could be the week when the World’s two most celebrated General Theories were proved correct. Both spell out the dangers of black holes. But whereas the risk of Earth disappearing into a cosmic black hole may be hypothetical, the liquidity black hole in global credit markets is here-and-now. Watch-out, we are being sucked in.

Could this be worse than the 2008 Lehman Crisis? Make no mistake it could be. Our Global Liquidity Index (GLITM) stands at 35.1 (‘normalised’ range 0-100) and only five points away from disaster, because a World recession is typically signalled at sub-30 readings. Our fear is that by moving now towards negative interest rates Central Bankers are making a very serious policy error. They may soon realise they have completely lost control. Keynes’ expressed this fear in the 1930s by warning of liquidity trap. Here all efforts by policy-makers to expand liquidity led to unlimited demands to hoard cash as risk aversion leapt. These ‘safe’ assets play an integral role in our credit system as part of its reserve and collateral base. Tampering can lead to disaster, and these latest attempts to effectively ‘tax’ cash holdings will push investors to hoard other ‘safe’ assets, thereby taking vital assets out of the credit creation process.

Central Bankers are turning to negative rates because they think QE (quantitative easing) has created more distortions than benefits. But the history of monetary systems plainly shows that there is a critical need to maintain the integrity and size of the monetary base from which credit can be built. Negative rates threaten to destroy these foundations. Credit supply is needed both for new capital projects and more importantly to roll-over existing debts. It depends upon the profitability of lending and the supply of reserves and collateral. All three are now being hit. The US Fed’s Reverse Repos are fast-depleting reserves in wholesale markets, while the whiff of negative rates is destroying bank profitability and causing insurance and pension funds to scramble into longer-dated bonds, driving their yields lower and thus cementing lower lending margins. Destroying the profitability of financial institutions will not create a stable credit system. As negative rates spread along the yield curve, the solvency of insurance and pension schemes will be threatened. Even our pensions may not be safe. Banks normal risk-taking operations will cease, so forcing them into doubtful ventures and raising fears over profitability and counterparty risk that echoes 2008. The vital wholesale lending markets that were at the centre of the last crisis will again dry up.

Negative rates may work on paper insofar that they lead to a steeper interest rate yield curve, but experience shows that they instead cause a massive curve flattening. Just like now. The problem is that in theory liquidity is fungible, but in practice as, every banker knows, it is does not flow in crises because it gets hoarded. In crises ‘safe’ assets are in high demand and trying to reduce the effective supply of ‘safe’ assets as policy-makers are currently doing spells credit suicide. This is what the latest collapse in Treasury term premia are telling us. Policy-makers need to target these term premia, rather than policy interest rates. The only way to get steeper yield curves, fatter lending margins and a self-liquifying global credit system is to expand the reserve and collateral base. Until then Global Liquidity is going lower.

Michael J. Howell is Managing Director of CrossBorder Capital, a London-based financial research company that advises key investors Worldwide. Prior to founding CrossBorder in 1996, Michael was Research Head at Barings and Research Director at Salomon Brothers. He can be contacted via liquidity.com.