Global liquidity to tighten

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“We are at a crossroads for extraordinary monetary policy. Much is misunderstood about the original purpose of QE, what impact it has had, and in turn, what impact its withdrawal is likely to have. These misperceptions exist right at the heart of our central banks, hence the risk of a major policy error cannot be ignored.”

– Neil Woodford

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. In the post-financial-crisis world, these relationships seem to have become more pronounced. But when dollar liquidity tightens, all of these things go into reverse.

We believe that liquidity conditions in the global financial system have started to contract and that this is likely to gather pace in the second half of the year. The primary reason for this is that central banks, led by the Federal Reserve (Fed), are now tightening policy.

The Fed has already increased interest rates three times this year (in March, June and September, each time by a quarter of a percent) and, if its dot plots are to be believed, we should expect rates to continue to rise gradually from here. With inflationary pressures building in the US economy, however, there is a risk that interest rates rise even faster and further than the market consensus currently anticipates.

Meanwhile, its quantitative tightening (QT) programme is causing global liquidity conditions to deteriorate further. On current plans, by the end of this year, QT will be draining an annualised $600bn from the financial system, with huge potential implications for global financial markets and the world economy.

We are already seeing the consequences of tighter liquidity conditions, most acutely in emerging markets, with steep declines in many South American and Asian stock markets and increasing signs of tension in foreign exchange markets. Although financial markets in the developed world have so far been relatively resilient to this development, the deterioration in global liquidity conditions will inevitably have an impact in the months ahead.

Financial Times

A stronger dollar means a lot more emerging market stress

The potential for trouble has been illustrated by the pressure on Argentina

9 May, 2018 John Authers

FT Logo

A stronger dollar means a lot more emerging market stress

The potential for trouble has been illustrated by the pressure on Argentina

The geopolitical outlook is, to use a word that has forced its way to the top of the political vocabulary this year, stormy.

But while the storms and risks are evident and appear to blow in different directions, they are in fact beginning to blow in one direction. Numerous pressures are pushing the dollar upwards, and exacerbating a global problem with the shortage of dollars.

The potential for trouble has been illustrated by the stress for Argentina — which has now followed raising interest rates by 10 percentage points in a week by asking for help from the International Monetary Fund — and Turkey. Both are emerging markets with specific and serious local issues, and a growing proportion of their debts denominated in dollars. But the problems could be far more widespread if the advance of the dollar continues, and they would not be limited to emerging markets.

The forces upwards on the dollar include the rise in crude oil prices, which is continuing following the US decision to leave Iranian nuclear agreement; resurgent political risk in Italy, which weakens the euro; higher short-term rates and quantitative tightening from the Federal Reserve that reduces dollar liquidity and increases the appeal of the dollar to foreign investors.

For both two-year and 10-year bonds, the yield differential of US over German bonds reached another high for the euro era on Wednesday. The 10-year Treasury yield took another trip above 3 per cent in Wednesday trade so the risk of a secular upswing remains real in the minds of traders.

The ugly trade negotiations with China, in which the US appears to many to be deliberately provoking a trade war, add to uncertainty and to upward pressure on the dollar.

The combination of dollar strength, tightening US financial conditions and political uncertainty has a well-established corollary: emerging markets weakness. That creates serious problems for the affected markets in the short term, including the risk of crisis if they cannot repay their debts. It also creates opportunities in the slightly longer term as emerging markets investments still tend to be indiscriminate, with flows entering and leaving “EM” as if is one coherent bloc, even though the differences in balance sheet management between different countries are growing ever wider.

Emerging markets government bonds, measured by JPMorgan’s EMBI index, are at their lowest since February 2016, when the world was in a scare over Chinese devaluation. The index has slid by 8.3 per cent since January.

Meanwhile, emerging market foreign exchange, also as measured by JPMorgan, is weaker than it was on election day, and close to its lows from the days after the election when an emerging market crisis appeared a real risk:

Emerging markets’ data have been disappointing of late, after a brief period earlier this year when they seemed to join a co-ordinated global recovery. The Citi emerging markets economic surprise index has turned slightly negative.

But the greatest issue is the stormy weather emanating from the US. As Jorge Mariscal, emerging markets chief investment officer at UBS Global Wealth Management, puts it: “The question is how the markets will interpret this sugar rush of fiscal stimulus that Mr Trump has injected. Will technology offset the inflationary pressure?”

He doubted that this would cause a generalised emerging markets issue, as there has as yet been no sign of contagion in Asia. He added: “Argentina and Turkey are vulnerable because their balance sheets are very exposed to the US dollar. Any sign that global liquidity is tightening is a problem. The bottom line, to quote Warren Buffett, is that when the tide flows back you can see who is swimming naked. The tide is pulling back and it’s revealing the countries with problems that were overlooked when liquidity was abundant.”

Should risk sentiment recover, there should be opportunities to buy emerging markets credits that have sold off unduly — Colm McDonagh, head of emerging market fixed income at Insight Investment, suggests the greatest opportunities are in the Middle East, Latin America and Asia, and also in the growing local currency debt markets.

But it is important to note that a dollar shortage does not merely affect emerging markets. According to the IMF’s latest Global Financial Stability Report, published last month, many non-US banks are reliant on dollar funding, particularly in Japan. Canada is also heavily reliant on US dollar funding. That means, as the IMF put it, that banks could “act as an amplifier of market strains” if they are compelled to sell assets into a turbulent market.

Mr Trump was elected to change the status quo, and he is doing so. The question is whether the stormy weather creates such a dollar shortage that other markets around the world cannot cope.

Copyright The Financial Times Limited 2018

© 2018 The Financial Times Ltd. All rights reserved. Please do not copy and paste FT articles and redistribute by email or post to the web.


Neil's view

As the era of easy money draws to a close, with the Federal Reserve intent on steadily shrinking the size of its substantial balance sheet, the implications for global liquidity and the US dollar pose a hazard for financial markets that have been paying too little attention to risk.21 December 2017

Ten years on from the global financial crisis, we are witnessing the product of the biggest monetary policy experiment in history. Investors have forgotten about risk and this is playing out in inflated asset prices and inflated valuations. Whether it’s Bitcoin going through $10,000, European junk bonds yielding less than US Treasuries, historic low levels of volatility or smart beta ETFs attracting gigantic inflows – there are so many lights flashing red that I am losing count.1 December 2017

Signs of liquidity stress appearing in interbank lending market?

Source: Bloomberg, Woodford

The LIBOR-OIS spread is seen as a measure of financial stress within the banking system - a widening spread suggests that interbank funding costs are rising relative to the risk free-rate. As the chart illustrates, there has been a very specific rise in dollar funding costs recently, which is indicative of diminishing dollar liquidity, globally.

Global liquidity conditions have tightened aggressively - and are likely to worsen

Source: MacroStrategy, Woodford

Global liquidity expected to continue tighteningQE 1QE 2QE 3% change20102012201420162018200920112013201520172019Excess global US$ money supply (6m annualised)-20-15-10-505101520 ? Fed tapers China bank bailout Yellen talks down the US$ Debt ceiling raised

Chinese money supply growth already slowing

Source: Bloomberg, Woodford

Implied path of future US interest rates

Source: Bloomberg, Woodford

How the funds will benefit

As well as the Fed’s tightening of monetary policy, we also have the reduction of the European Central Bank’s (ECB) extraordinary monetary policy to contend with. In combination, we believe the impact of this deterioration in global liquidity conditions will act as a brake on economic growth and on financial asset prices around the world, with very few regions looking capable of escaping the fallout. With equity markets pricing in perfection for the global economy, this will come as a shock to a complacent consensus.

There is one developed economy, however, whose money supply growth outlook is not facing the impact of the withdrawal of extraordinary monetary policy. The UK economy has sustained nominal broad money supply growth of around 5% per annum recently – this, coupled with all the other positive trends in the UK economy that we have been highlighting, is enough to suggest that domestic growth can accelerate in the months ahead, leaving consensus expectations looking far too low.

Our contrarian strategy has actively avoided areas of the market that look most vulnerable to the withdrawal of liquidity, focusing instead on stocks, particularly domestically-focused companies here in the UK, that have not benefited from abundant liquidity. As always, valuation guides this disciplined investment approach.

LF Woodford Equity Income Fund (as at 30 November 2018)

Geographical allocation
Country Fund (%)
United Kingdom 86.46
United States 12.79
Norway 1.11
Ireland 0.75
Switzerland 0.62
Luxembourg 0.47
Sector allocation
Industry Fund (%) Benchmark (%)
Financials 36.78 25.70
Health Care 23.47 10.32
Consumer Goods 21.39 13.71
Industrials 14.48 10.62
Technology 4.83 0.94
Consumer Services 1.21 11.45
Basic Materials 0.05 7.35
Telecommunications 0.00 3.17
Utilities 0.00 2.76
Oil & Gas 0.00 13.99
Cash and near cash -2.20 0.00
Total 100.00 100.00

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