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.
Liquidity issues are affecting emerging markets
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 US$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.
The effects of lower liquidity are spreading
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.
Normalization is not the only force affecting liquidity
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 does not mean that investors should abandon financial markets; instead, I believe they should prepare for potentially higher volatility in both equities and fixed income. For investors with lower tolerance for volatility, asset classes that have historically offered lower volatility, such as dividend-paying stocks and low volatility factor investments, may be options to consider. And of course, broad diversification that includes adequate exposure to alternative asset classes may also help reduce overall volatility of the portfolio.
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.
- The BOJ will meet and follow with a press conference, as will the BOE.
- The BOE is in a difficult position given the economic policy uncertainty created by Brexit. It is expected to raise rates, but I’m of the belief that this would be a mistake — and I hold out hope that the BOE will stand pat at this meeting.
- The central banks of Brazil and India will also meet; I am sure one area of focus will be the current liquidity situation.
- Finally, the Fed will also be meeting. It is expected to send a powerful message that more rate hikes are coming (despite market doubts). While the Fed may be telegraphing that message, I still believe a fourth rate hike this year will be very dependent upon the economic data we see in the coming months — this is not a done deal. I do hope to hear more about balance sheet normalization, its impact on liquidity and, although unlikely, any possible adjustments to the current plan in light of liquidity issues.