In this inter-connected, globalised economy, dollar liquidity is key. Its importance as the grease in the wheels of the global financial system is easily under-estimated. In simplistic terms, when dollar liquidity is abundant, global trade tends to be strong, the dollar is typically weak, commodity prices rise and equity markets do well. But when dollar liquidity tightens, all of these things go into reverse. In the post-financial-crisis world, these relationships seem to have become more pronounced.
Liquidity conditions in the global financial system deteriorated meaningfully in 2018, with central banks, led by the Federal Reserve (Fed), tightening monetary policy. The Fed increased interest rates four times in 2018, in response to a rapidly growing US economy, a strong domestic labour market and concerns about building inflationary pressures. Although that policy may have been justified from an American perspective, it increasingly caused problems for many other parts of the global economy, particularly in emerging markets, which borrowed heavily in dollars whilst they were cheap.
Meanwhile, the Fed’s quantitative tightening (QT) programme has drained considerably more liquidity from the global financial system, with huge implications for global financial markets and the world economy. The European Central Bank has also stopped its own form of extraordinary monetary policy – prematurely, in our view, because the European banks are not yet fit to lend.
The Fed’s most recent comments reflect growing unease about the health of the US economy. The next move in US interest rates may therefore be down and QT is due to end earlier than previously expected. Nevertheless, with the lagged effects of tighter monetary policy yet to be felt, the damage may already be done.
We expect tighter liquidity conditions to increasingly bear down on global economic activity over the remainder of 2019, with very few regional economies possessing enough internal momentum to withstand the slowdown that is already in train.
This, in turn, will make it difficult for many businesses to meet elevated profit expectations. Coupled with a backdrop of excessive valuation in stock markets, this is a potentially dangerous combination. The comfortable consensus view that prevails in equity markets globally is about to be challenged.