Why we’re watching liquidity

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For financial professionals only

Liquidity greases the wheels of the financial system - and with equity markets near record highs in the US, Germany, Japan and even showing tentative signs of awakening in Emerging Markets, everything seems to be fine, right? 

Well, that remains to be seen.

Following the rapid increase in interest rates, money supply has been contracting in much of the developed world since December 2022 (as you can see in the US money supply (M2) chart below). Combined with central banks’ quantitative tightening, this raises the risk of market dislocation – and that’s something markets are not currently focussing on.

US M2 growth and PCE inflation

chart showing US M2 Growth And PCE Inflation

Source: FRED, Federal Reserve Bank of St. Louis

So far this year, markets have been functioning well.  Record US investment grade debt issuance in January of $196bn was comfortably absorbed with buoyant investor demand, leading to a narrowing of spreads to below historical averages.

The BoE has almost completed the sale of the £20bn corporate bond holdings it accumulated through QE. Selective write downs of commercial real estate in the US have barely budged the positive sentiment and momentum percolating through markets. 

What remains unclear is whether we’ve yet to see the full impact of the extraordinary increase in interest rates that took effect in 2022/23.  With households and corporates locked into low rates of borrowing for longer, the ‘long and variable lags’ of monetary policy via the transmission mechanism is taking time to take effect. 

However, it may be wise to assume this is just a delay and we should be vigilant for signs of fragility and weakness. Markets are not priced for bad news at this time.

The Fed is wary of a squeeze

Early signs of stress in the system are indicated by the level of activity in the Reverse Repo market. This is where banks, money market funds and other financial institutions park excess liquidity overnight, earning an incremental return whilst retaining flexibility and accessibility.  As you can see in the chart below, this has been shrinking at pace since early last summer, a red flag of a growing risk of contraction in liquidity.

Fed overnight reverse repo facility

Chart showing Fed Overnight Reverse Repo Facility

Source: Bloomberg and TwentyFour Asset Management as at 30/11/2023

In the US, this could be compounded by the expiry of the Bank Term Funding Program in March and heightened focus on the quality of bond collateral,  just as underlying liquidity is gaining greater attention amongst all financial market participants. 

Add the growing number of defaults in high yield bonds, rising delinquency rates in credit cards, auto and unsecured consumer loans, and you can see why banks are tightening the reins on their balance sheets, loan books and lending criteria. Risk mitigation becomes the primary focus when moving into an expected period of slower growth.

The weight of responsibility on central banks

Central banks are responsible for financial stability and price stability, which might explain their more dovish commentary on interest rates at the end of last year, despite solid macroeconomic data continuing to come through. 

As they endeavour to thread the needle to a soft landing, they have a challenging path to tread. Stay too restrictive for too long and a slowdown could turn into a recession. Relax policy too early and inflation may resurface. Either way, ensuring continued financial stability is equally important – more so than many investors appreciate. 

A fundamental building block within financial stability is liquidity, so great care is needed to ensure that deliberate policy tightening to quash inflation doesn’t become too tight and restrictive.

As a result, there is growing pressure on central banks to ease rates through 2024 and into 2025, though change is likely to be slow and steady rather than fast and furious.

Money markets - a source of funds

One area of the market that could help central banks’ liquidity challenge is money market funds. Money market funds were huge beneficiaries of the hike in interest rates, as savers sought refuge from the volatility seen in 2022 and were attracted by the risk free nominal yield of 5%+. 

US money market funds grew to over $6 trillion, representing 22% of US GDP. Looking forward, this could be a potential large and liquid source of funds. If interest rates decline, as markets currently expect, a chunk of this may well seek higher returns elsewhere - such as in longer duration government bonds and investment grade corporate bonds. At a time when debt:GDP ratios are elevated, this source of additional buying could be timely.

Quality diversification

The outlook remains challenging, with continued market volatility, but there‘s cause for optimism as we pass the probable peak in interest rates. 

However, given the speed and magnitude of interest rate increases over the last two years we believe it’s vital to stay disciplined, diversified and up in quality to navigate the path ahead. Unexpected surprises might just be round the corner, and a squeeze in liquidity could be one of them.

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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