Can weak markets be explained by changes in bank balance-sheets?
ECONOMISTS have been a bit puzzled by the market turmoil of early 2016. It seems to be driven, in part at least, by fears of either an American recession, or a sharp Chinese slowdown, neither of which looks likely from the data. Perhaps the answer to the conundrum is that market movements are not being driven solely by fundamentals but by recent developments in market liquidity.
Central banks’ support for markets, via quantitative-easing (QE) programmes, is well known.
Emerging-market central banks have also been big buyers of government bonds as they have built up their foreign-exchange reserves. But the Federal Reserve stopped its QE programme in 2014 and, in recent months, Chinese foreign-exchange reserves have fallen by around $700 billion. This means the Chinese authorities are net sellers, rather than buyers, of financial assets. Low oil prices mean that sovereign-wealth funds in oil-producing countries may also be selling assets.
CrossBorder Capital, a research firm, says that the combined balance-sheets of the Federal Reserve and the People’s Bank of China were growing at more than 10% a year for much of the past decade—and reached a peak of 64.5% growth in 2008. But over the past year, they have actually contracted (see chart). Both the European Central Bank and the Bank of Japan are still adding assets, of course. Nevertheless, CrossBorder’s global liquidity index, which reflects changes in the balance-sheets of a range of central banks, has fallen to 35; a world recession, says the firm, is signalled when the index drops below 30.
Central banks may not be the only factor affecting market liquidity. Matt King, a credit strategist at Citigroup, highlights a number of oddities in a recent research note. The first is the relationship between government-bond yields and the cost of interest-rate swaps. A swap involves two parties agreeing to exchange a fixed-rate payment for a floating rate based on a variable measure, such as Libor. Since the counterparties to such deals tend to be from the private sector (notably banks), the fixed-rate element of the swap has tended to pay a higher yield than the equivalent government bond, to reflect the greater risk. But the cost of swaps has fallen below Treasury-bond yields, a phenomenon dubbed a “negative swap spread”.
The other shifts are in the corporate-bond market. Investors with a strong view on where the bond market is heading can buy or sell individual bonds, or they can use a derivative called a credit default swap (CDS). A CDS is a kind of insurance policy, which pays out if the bond defaults; when corporate-bond prices are falling, the cost of a CDS rises. Mr King points out that the cash market has recently, and unusually, underperformed the derivative (ie, the spread, or excess interest rate, on corporate bonds has risen faster than the cost of insuring against default via a CDS).
In a similar shift, the cost of insuring against the default of individual companies has risen faster than the cost of insuring a corporate-bond index. These changes in relative prices are the opposite of what happened in the crisis of 2008. Back then, the most liquid markets were the quickest to show the pain.
Mr King’s explanation is that this is all to do with the reluctance of banks to tie up their balance-sheets, thanks to new rules on leverage ratios. Derivatives like swaps require banks to put aside very Little capital compared with owning cash bonds, and so reduce demand for the latter. Banks are also unwilling to provide finance to traders who want to arbitrage such price disparities away; profiting from small price differences requires lots of borrowed money.
Another sign that liquidity is shifting can be seen in the world of exchange-traded funds (ETFs)—portfolios of assets that can be traded on the stockmarket. According to BlackRock, which operates the biggest high-yield ETF, daily trading in the fund was briefly worth a quarter of the value of all American corporate-bond trading in December. Buying and selling an ETF has become a more liquid way of shifting an investor’s asset allocation.
Since the crisis commercial banks seem to have retreated from their market-making role. The impact of this shift has been disguised by the huge amounts of liquidity injected by central banks. But as central banks scale back their support, the underlying investors (pension funds, insurers, hedge funds and the like) will have to rely on each other to act as willing buyers and sellers. That seems highly likely to result in more volatile markets than in the past, especially when the outlook for the economy is unclear. Buckle up.