Fed U-turn should put liquidity back in the spotlight

Investors should remember that return of capital is as important as return on capital

Laurence Fletcher

For much of the past decade, the state of financial market liquidity has been a nagging, but not overly pressing, concern for investors.

Hedge funds have at times grumbled about the difficulty in getting firm prices for corporate bonds from market-making banks. Carrying out bigger bond trades has on occasions proved tricky. But these have been minor problems. Investors have generally been able to buy and sell as they please.

But a bull market covers a multitude of sins. When returns are positive, such complaints seem trivial and it is easier to forget about the potential problems in selling assets down the road. Hedge funds which stopped investors withdrawing their money during the financial crisis seem a dim and distant memory, even though some of those vehicles that tied up investors’ cash are still bouncing round the secondary markets even today.

However, there are now strong indicators that investors should be paying much more attention to how easily and how quickly they can get their money back.

“Liquidity will be seen as the channel from the last crisis to the next one,” said Pascal Blanqué, chief investment officer at funds giant Amundi, which manages €1.47tn in assets. He blames quantitative easing for having pushed down bond yields and forced investors into a “frantic search for yield” in thinly-traded corners of the market.

A number of warning lights have been flashing possible problems ahead. And they have not been limited to junky assets.

In late May last year, for instance, when Italian two-year government bonds posted their worst trading day in decades, fund managers trading the country’s bond market found that it took much longer to unwind positions and found a real lack of buyers for blocks of bonds beyond a certain size.

In December, liquidity in S&P 500 “E-mini” futures contracts tumbled to multiyear lows, which is likely to have exacerbated the market sell-off, according to Deutsche Bank research. Median order-book liquidity for the contracts that month fell across the entire trading day and was at the bottom of its three-year range, says Deutsche.

And even German Bunds, among the most liquid of all assets, got hit. Guillaume Lasserre, chief investment officer at Lyxor Asset Management, reported that one of his portfolio managers had difficulties buying Bunds at the end of last year, such was the demand from other investors wanting to keep them on their balance sheets.

Some of this has been exacerbated by fundamental changes to the structure of the market.

Under pressure from regulators, banks have sharply cut back their market-making activities. Primary dealers’ inventories of corporate bonds have plunged from $285bn in late 2007 to $14bn last month, according to FRB/Amundi research. Meanwhile, the total stock of US corporate bonds outstanding has climbed from $2.8tn to $5.5tn (as of September 2018).

With banks increasingly unwilling to hold bonds on their balance sheets, instead preferring to operate by simply matching buyers and sellers, there are fewer ‘shock absorbers’ in the market when investors need to shift large blocks of bonds. Risk has shifted from the banks to the market.

Meanwhile, another radically-changed market untested by a crisis is the exchange traded fund (ETF) market, which now holds about $4.6tn, according to consultancy ETFGI. Some fear that rapid growth will bring poorer price discovery and increased correlation between investors — a potential danger when everyone tries to rush for the exits at once.

“Market structure and liquidity have changed significantly,” wrote Michael Hintze, founder of hedge fund CQS, in a recent investor letter. “Consequently, we will continue to see lower levels of overall volatility punctuated by gapping markets and rapid mean reversion.”

One further area where investors may find expectations do not meet reality is in Ucits funds. These European-domiciled funds have attracted billions of euros because they are regulated and offer frequent redemptions — at least twice a month but usually daily.

However, last year’s suspension, and then liquidation, of GAM’s Absolute Return Bond funds is a reminder that the assets held in Ucits funds may be harder to get at. Such funds may offer rapid access but also have the power to suspend redemptions — often at the time when investors want their money back most.

Investors now find themselves at a tricky juncture. On the one hand the ending of the European Central Bank’s bond-buying programme appeared to have changed market conditions. Volatility, suppressed by QE for so long, spiked in the fourth quarter, pushing liquidity to the front of minds. On the other hand, the Federal Reserve’s dovish comments last month have calmed volatility, on hopes of easy monetary conditions ahead and potential flexibility in how the Fed unwinds its balance sheet. The good times could continue.

Some investors such as pension funds and insurance companies can afford to lock up assets for years and are in a great position to exploit long-term opportunities in illiquid assets. But for everyone else, the Fed’s U-turn last month offers more time to work out how quickly they can get their money back.

Financial Stability in Abnormal Times

Despite improvements in the financial system since the 2008 crisis, the piecemeal reforms that have been enacted fall far short of what is needed. And an inexorably growing financial system, combined with an increasingly toxic political environment, means that the next major financial crisis may come sooner than you think.

Kenneth Rogoff

fearless girl statue snow

CAMBRIDGE – A decade on from the 2008 global financial crisis, policymakers constantly assure us that the system is much safer today. The giant banks at the core of the meltdown have scaled back their risky bets, and everyone – investors, consumers, and central bankers – is still on high alert. Regulators have worked hard to ensure greater transparency and accountability in the banking industry. But are we really all that safe?

Normally, one would say “yes.” The kind of full-blown systemic global financial crisis that erupted a decade ago is not like a typical septennial recession. The much lower frequency of systemic crises reflects two realities: policymakers respond with reforms to prevent their recurrence, and it normally takes investors, consumers, and politicians a long time to forget the last one.

Unfortunately, we don’t live in normal times. Crisis management cannot be run on autopilot, and the safety of the financial system depends critically on the competence of the people managing it. The good news is that key central banks still, by and large, have excellent staff and leadership. The bad news is that crisis management involves the entire government, not just the monetary authority. And here there is ample room for doubt.

To be sure, if the next crisis is exactly like the last one, any policymaker can simply follow the playbook created in 2008, and the response probably will be at least as effective. But what if the next crisis is completely different, resulting from say, a severe cyberattack, or an unexpectedly rapid rise in global real interest rates, which rocks fragile markets for high-risk debt? Can anyone honestly say that US President Donald Trump’s administration has the skill and experience to deal with a major collapse? It is hard to know, because the only real crisis the United States has experienced so far during Trump’s presidency is, well, Trump’s presidency.

US Federal Reserve chair Jay Powell and his team are first-rate, but who will be the other adults in the room if an externally generated financial crisis threatens? The Fed cannot begin to do everything on its own; it needs both political and financial support from the rest of the government. In fact, the Fed has less room for maneuver than it had in 2008, because the 2010 Dodd-Frank financial reforms sharply restricted its ability to bail out private institutions, even if the entire system might otherwise collapse. Will a gridlocked Congress deliver? Or perhaps Steven Mnuchin, who produced Hollywood movies prior to becoming US Treasury Secretary, can use insights from his acting role in the 2016 movie “Rules Don’t Apply.”

Europe has issues that are similar, or worse. With populism fueling deep distrust and divisions, financial resilience is almost certainly far lower than it was a decade ago. Just look at the United Kingdom, the other major global financial center, where the political elite have taken the country to the edge of the Brexit cliff. Can they really be expected to handle competently a financial crisis that requires tough political decisions and agile thinking? The UK is fortunate to have very good staff in its Treasury as well as its central bank, but even the brightest boffins can do only so much if politicians don’t give them cover.

Meanwhile, across the English Channel, deep division over eurozone burden sharing will make it difficult to implement a cogent policy for dealing with a bout of severe stress. A significant rise in global real interest rates, for example, could wreak havoc in the eurozone’s balkanized debt markets.

But won’t it be another 20-40 years before the next big financial crisis, leaving plenty of time to get ready? One hopes so, but it is far from certain. Even if regulations have been successful in containing risks to banks, it is likely that major sources of risk have simply migrated to the less regulated shadow financial system. What we know for sure is that the global financial system continues to expand, with global debt now pushing $200 trillion. Better financial regulation may have helped contain the corresponding growth in risk, but it is not necessarily shrinking.

For example, although big banks do seem to have less risk “on the books,” regulators must work hard to monitor risky debt that has migrated to the shadow financial system and can inflate quite quickly, as we learned the hard way in 2008. Regulators are quick to point to banks’ higher buffers of “liquid” assets to fight runs on deposit and debt-rollover problems. Unfortunately, assets that are “liquid” in normal times often turn out to be highly illiquid in a crisis.

Policymakers are right to say there have been improvements in the system since 2008. But the piecemeal reforms that have been enacted fall far short of what is most necessary: requiring banks to raise a larger share of their funding through equity issuance (or by reinvesting dividends), as economists Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute have argued. Unfortunately, an inexorably growing financial system, combined with an increasingly toxic political environment, means that the next major financial crisis may come sooner than you think.

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. The co-author of This Time is Different: Eight Centuries of Financial Folly, his new book, The Curse of Cash, was released in August 2016.

The Global Trade Slowdown Will Get Worse Before It Gets Better

Surprisingly strong Chinese trade data for January are looking like an outlier, given this week’s soggy numbers from Japan and Korea

By Mike Bird

Containers at the Yangshan Deep Water Port in Shanghai, China. The big gap in Chinese and Japanese trade data is a bad sign for global economy optimists.
Containers at the Yangshan Deep Water Port in Shanghai, China. The big gap in Chinese and Japanese trade data is a bad sign for global economy optimists. Photo: aly song/Reuters

A week is a long time in global trade, apparently. Weak data from Japan and Korea this week suggest stronger-than-expected January trade numbers from China released last week were a blip. For investors focused on the outcome of U.S.-China trade talks, the message is clear: Pay more attention to the global slump that’s already under way.

The discrepancy between Chinese and Japanese trade data is one bad sign for global economy optimists. Chinese statisticians recorded a 2% month-over-month fall in imports from Japan in January, while Japan recorded a 31.7% fall in exports to China over the same period. That’s the biggest divergence between the two data sets in eight years.

The bad news is that such big data gaps are typically resolved to more closely match Tokyo’s numbers. In February 2011, Japanese and Chinese trade data diverged by 46.7 percentage points; the following month, Beijing recorded a 46.5% boom in imports from Japan. On that basis, China’s imports from Japan are likely to look miserable in February’s data.

Korean trade figures released Thursday, which cover the first 20 days of February, also suggest that the contraction in global trade is continuing, not reversing. Exports and imports fell by 11.7% and 17.3% respectively year over year, the worst figures for each since mid-2016. Exports to China fell by 13.6%.
Korea’s weakness today means global weakness tomorrow thanks to its position at the center of many international supply chains. Machinery components exported from Korea to other Asian countries often become finished products that are exported to Europe or the U.S. weeks or months later.

Blaming U.S.-China trade tensions alone misses the mark: The current global trade slump began well before the U.S. first imposed tariffs last May. The true leading cause of the slowdown—particularly in intra-Asian trade where the steepest declines have been recorded—is China’s fading growth. So while any deal between Washington and Beijing would be good for their exporters and investors, it likely won’t reverse the broader global trade malaise.

A real global trade recovery will instead have to wait for China’s own economic stimulus efforts to feed through. That could yet take several months, even after January’s record rise in Chinese credit. The message for now: Don’t get carried away by one outlying set of trade data.

Europe Has America’s Globalization Problems on Steroids

The eurozone is grappling with a slowdown in China, but its regional divergences are a much bigger long-term issue

By Jon Sindreu

Traditional powerhouse regions in France and northern Italy have lost ground to Germany in recent years. This picture from 2014 shows a closed Michelin tire factory in central France.
Traditional powerhouse regions in France and northern Italy have lost ground to Germany in recent years. This picture from 2014 shows a closed Michelin tire factory in central France. Photo: guillaume souvant/Agence France-Presse/Getty Images

Two decades after the launch of Europe’s single currency, the eurozone is again flirting with recession. It is fashionable—and reasonable—to blame the euro’s unfinished design, but even the most radical currency reforms wouldn’t solve the continent’s biggest underlying problem: Regional inequality.

Recent data has showed Italy in recession and Germany very close to one amid challenges for its car industry. Mercedes-maker Daimler cut its dividend Wednesday following a run of profit warnings. Europe’s growth strategy in recent years has been to focus on exports, which are now vulnerable given the slowdown in China.

The euro does bear a lot of blame. Unlike the dollar, the common currency isn’t backed by a single sovereign debt market that allows for mutualized government spending during crises.

This leads to bouts of high unemployment in Southern Europe and recurrent financial panics such as last year’s Italian debt crisis.

But the bloc’s challenges go much further than just pooling debts—which has already proven difficult. German cars are one of a diminishing number of increasingly powerful engines on which the European economy has come to rely.

Since the 1970s, productivity has become concentrated globally in companies big or specialized enough to hog a large share of their market. Economies of scale have always powered economic development, but globalization has multiplied their rewards. The fate of regions hosting winners and losers has diverged, with regional inequality rising sharply across the world—including the U. S.—and fueling the rhetoric of antiestablishment parties.

But economic integration has been more ambitious in Europe than elsewhere. Regional disparities have surged, according to a data set by economic historians Joan Rosés and Nikolaus Wolf stretching back to 1900. The winners have been capitals where big banks and other multinationals have set up shop, such as Paris, London and Madrid, as well as regions hosting Europe’s top industrial companies and their supply chains, such as Germany’s Bavaria—home to Siemensand BMW .The losers are former bastions of heavy industry, including some regions within Germany itself.

Sure, catch-up growth in countries recovering from dictatorships like Spain and Greece and development spending by Brussels did allow some poorer regions to outperform in the run-up to the financial crisis.

Yet most of them faltered after 2008. Only traditional powerhouse regions in France and northern Italy are left to lead growth, but they lost ground to Germany after the euro’s creation in 1999 eliminated some remaining trade frictions. And unlike the U.S. and China, Europe has missed out on building up its own technology sector. 

Countries are morphing into large economic peripheries lagging a few ultra-productive centers.

This problem is particularly intractable for a bloc where language and cultural differences disincentivize workers to move. Necessary steps toward integration may even aggravate it: A more consolidated European banking union is likely to focus credit on fewer regions than before.

Germany’s export problems may pass. The continent’s divergence between a productive center and unproductive periphery looks worryingly permanent.

How the Fed’s Wait-and-see Stance Helps the Markets

Wharton's Peter Conti-Brown and Rodney Ramcharan from the University of Southern California discuss the Federal Reserve's wait-and-see approach to raising interest rates.

Last week, the Federal Reserve decided to pivot to a wait-and-see stance on interest rates after raising them at a regular clip since December 2015. “The U.S. economy is in a good place,” Fed Chair Jerome Powell said in a Jan. 30 press conference. However, “in light of global economic and financial developments and muted inflation pressures, the [Federal Open Market] Committee will be patient as it determines what future adjustments to the target range of the Fed Funds Rate may be appropriate.”

The global developments giving the Fed pause include slowing growth in some major foreign economies, particularly China and Europe, the economic impact from Brexit, the fallout from trade wars and a possibly prolonged federal government shutdown. “The cumulative effects over the last several months warrant a patient wait-and-see approach regarding future policy changes,” he said. What traditionally has forced the Fed’s hand to raise rates was the specter of high inflation. But this risk “appears to have been diminished,” helped by lower oil prices, Powell said.

Wharton finance professor Jeremy Siegel, who recently predicted that the Fed would not raise rates in 2019, said the FOMC should have pivoted in December, when stocks had a mini-bear market. “It was then they should have decided we are not going to raise anymore,” he said recently on the “Behind the Markets” show on Wharton Business Radio, SiriusXM channel 132. “The markets said, ‘You better not [raise rates],’” and now the Fed is finally listening.

According to Siegel, the Fed sees signals that the U.S. continues to have a robust economy but with inflation fears easing a bit. He cited the January employment report from the Bureau of Labor Statistics (BLS) showing a gain of more than 300,000 non-farm jobs, which was a larger increase than expected. Meanwhile, the jobless rate, which is culled from another BLS survey, edged up to 4% from 3.9% the month before. “We like to think about unemployment rates going up as negative, and yet it gives us slack in the labor market and does not put pressure on wages, which is the thing that you’re worried about in terms of putting pressure on costs that will lead to inflation,” he said. “This is absolutely great news.”
The trends are “very strong,” Siegel continued. “No signs whatsoever of recession.” The only little “wobble” in economic signals was the greater-than-expected increase in jobless claims, but it could be due to the teachers’ strike in California, he added. “But on all other data, that so-called ‘recession scare’ is kind of getting out of the market,” Siegel noted. The Fed “gave everything the market wanted — pivoted to a ‘wait and see.’” He believes the Fed largely would stand pat as they closely watch incoming economic data, with perhaps a hike at the end of 2019.

After the Fed’s announcement, the stock market is rebounding and Siegel sees more upside. Stocks are trading at a little more than 17 times 2018 earnings, or put another way, slightly above 16 times this year’s earnings. “The 16 to 17 range in a low interest rate world is not an expensive market,” he said. “I can still see people piling in.” Siegel also believes value stocks will outperform growth stocks in 2019 for the first time in a couple of years. Moreover, “I think the bottom is in for emerging markets. Technically, it’s in triple bottom. The psychology has changed — not just foreign but value stocks,” Siegel noted. A triple bottom pattern in a stock chart signals that the price is headed up. 
With the change in the Fed’s stance, President Trump cannot blame Powell anymore for any stock market declines, Siegel said. In the past few months, Trump had been blaming the Fed’s rate hikes for stock prices falling. But now with the Fed on pause, “anything that goes wrong from a policy perspective is on Trump’s shoulders,” he said. “He certainly knows that if he imposes 25% tariffs and we don’t come to a reconciliation or at least another big delay to work on this, the decline in the stock market — and there would be a decline — is on him.”

Politics at Play?

Given that the Fed shifted its stance after enduring months of Trump’s accusatory tweets, was the central bank pressured by politics? “I think it’s unlikely that the [Federal Reserve] Board would take pressure from President Trump into account,” said Wharton finance professor Richard Herring in an interview with Knowledge@Wharton. And Trump’s antics might even backfire. “They may be less likely to move in the direction he advocates to avoid the appearance that the Fed is losing its independence.”
Instead, “pressure from the market disruption in December may have had an influence” in the Fed’s dovish stance as it continues to watch economic data, Herring said. Powell is “simply affirming that the Fed will continue to be data dependent,” he said. “The global uncertainties — Brexit, slowing of growth in China and Europe, the prospect of deteriorating trade conditions plus the surprising lack of evidence of rising inflation — provide reasons to be more cautious about tightening.” But all that could change if the U.S. economy remains strong and inflation begins to surge. “I would expect them to resume tightening,” Herring added.

Wharton finance professor Krista Schwarz agreed. “I do not believe that the Fed is acquiescing to political pressure. A shift in the market’s perception of the Fed’s independence could seriously hamper the effectiveness of the monetary policy transmission mechanism,” she said in an interview. “The Fed’s leadership is keenly aware of this risk.”

Schwarz, who used to work at the New York Federal Reserve Bank, said the Fed’s policy objective “has not changed with regard to inflation and the labor market, but the prevailing risk environment has. That said, Powell communicated more of a wait-and-see stance rather than an explicit shift.” She noted that the Fed funds futures contracts “continue to show consensus expectation for no further rate changes through the end of the year, with little change since the FOMC meeting.”

But what’s interesting is that several of the risk factors Powell cited are tinged with politics: Brexit, trade wars and the government shutdown, said Peter Conti-Brown, Wharton professor of legal studies and business ethics who wrote the book, The Power and Independence of the Federal Reserve, on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.) The Fed is not just taking into account broader financial trends such as secular stagnation, durability of the Phillips Curve (that links rising wages to unemployment), he said. “It’s actually pretty reassuring that the FOMC generally is trying to go slow and understand the change in the world as it changes before them.”

Taking a wait-and-see approach is “the wisest way,” added Rodney Ramcharan, associate professor of finance and business economics at the University of Southern California who was the first chief of the Systemic Financial Institutions and Markets Section at the Board Governors of the Federal Reserve System. He joined Conti-Brown on the radio show.

“The fact that inflation sort of stays below the 2% [target] threshold means that the Fed has the luxury … to wait out the uncertainty because there’s no reason to necessarily jump in and act at this point,” Ramcharan said. But if “uncertainty continues to persist, the Fed may have a lot less room to wait. It may have to act to forestall a rise in inflation rates [above the target] if that takes place.”

However the history of the Fed shows that it is not always above politics. Ramcharan pointed to the early 1970s when the Fed Chair was Arthur Burns, an appointee of President Nixon. Burns caved to political pressure and followed an expansionary policy of lowering interest rates despite fears of inflation. What followed was a period of high, even double-digit, inflation in the U.S.

“We knew the White House was putting a lot of pressure on the Fed to not raise rates and that led to a lot of inflation,” Ramcharan said. “That’s a theme that we’ve seen throughout the world — when central banks are not independent, when central banks cannot act in a manner that is consistent with their objectives alone and not the politics, things tend to go badly.”

Starting in the late 1970s, in the U.S. and across the globe, “central banks and governments recognized that we need to act to make central banks as independent as possible,” Ramcharan said. He credited President Jimmy Carter’s appointment of Paul Volcker as Fed chairman to be a key moment. Volcker “acted independently, [even] against the interest of Carter, [by raising rates] to get the inflation rate down.” Since then, “that’s the precedent that we have [had],” he said. “You put the right person in power and let them act in accordance with the objectives of the institution and we all, as a society, get the best outcomes.”.