What's driving markets today?
I’m going to start this blog with a minor blast on my own trumpet. Over the past few months, I’ve written about slowing economic growth, sideways equity markets, falling bond yields and a rising gold price. And so it has come to pass. In particular I stood up at a conference in early May and said that US 10 year bond yields, then 2.5%, would certainly fall to 1.5%, and might go to Japanese levels of 1% or even negative. There were whistles of derision all round, but where are they now? 1.68% is the answer.
As regular readers will be aware, the credit should really go to my friends at CrossBorder Capital, whose work on liquidity data I find an invaluable framework. Ultimately, whatever ‘experts’ write, what moves markets is weight of money moving in or out. That is why following ‘funding liquidity’ (i.e. credit or cash which can be used to settle a liability) is crucial to understanding markets.
There are really two major themes today. The first is driven mainly by central banks, and especially the Federal Reserve and the Peoples’ Bank of China. Over the past two years, for different reasons, both embarked on tightening policies. The Fed in 2017 started to normalise interest rates; the Chinese in 2018 needed to support the yuan in the light of growing trade tensions.
In 2019, both have abruptly changed course. The Fed signalled a neutral posture in January, and cut rates in August. The Chinese in May started to inject liquidity back into their system – the yuan’s fall below 7 yuan to US$1 is simply a consequence of easing.
There’s always a lag of 12 to 15 months between liquidity tightening and economic slowdown. It is no surprise that the world’s economy is struggling today and may indeed fall into recession. It’s worth noting here that the Chinese multiplier is both larger and more direct than the US; i.e. the PBoC has more control over its economy.
However, the seeds of exiting the slowdown are also in place with change of monetary policy. Both central banks have accepted that easier monetary policy is the only rational escape route, and so any recession is likely to be mild. Call it QE4 if you want.
The second major theme is to do with how the private sector refinances its debt. There is plenty of cash sitting in corporate and institutional investors’ hands. There are plenty of corporates out there who need finance. The problem is the mismatch between risk appetite and what is on offer. In other words, liquidity is not fungible.
The problem has largely been skirted by the use of repos, so that lenders to riskier ventures are collateralised with ‘safe’ assets such as US Treasuries. Financing is short-term, requiring regular refinancing and a supply of safe assets to provide collateral. The consequence of this is that the availability of liquidity and particularly of ‘safe’ assets becomes more important than the price paid.
Ironically, the need to refinance more frequently adds to the risk of systemic problems. That in my view is a major reason behind the Fed.’s decision to expand its balance sheet. It’s also why US bond yields are headed downwards – price matters less than availability.
Both these themes lead in the same direction: QE4 of some description, a steepening yield curve, some downside protection for equities, and at worst a mild recession. For what it’s worth, I also believe we will wake up one morning to some form of accommodation on the trade front: neither Xi nor Trump can really afford not to.