Global Liquidity

Liquidity could be the big challenge in the coming year…

In a world that is obsessed with a plethora of problems ranging from slow growth to weak inflation to a highly intransigent North Korea, there is a hidden problem that could be lurking in the corners. In the year 2018, global liquidity could be the big story to watch out for.

Lehman story in reverse… 

Back in 2008 when Lehman brought the global financial markets to the brink, the central banks had only one choice. They had to infuse liquidity in abundance so that the sheer power of liquidity would support asset prices. That is exactly what happened as global asset classes rebounded to pre-crisis levels, despite no visible growth. The reason was liquidity. So, how did central banks infuse liquidity into the system? They did so by buying all kinds of securities from the market. When the central bank buys securities, it builds its own securities portfolio and in the process infuses liquidity into the financial system. It is this induced liquidity that has kept markets and assets prices buoyant in the last 9 years. The US Fed took its bond portfolio from $1 trillion in 2008 to $4.5 trillion in 2017. The US Fed was not alone. The Bank of Japan and the ECB have also created bond portfolios of equivalent amount. Bank of England has also created a portfolio of close to $2 trillion. With inflation going up and growth returning, it is time to reverse the process. That is the worry!

Action from the Fed and ECB… 

The US Fed was the first to announce a tapering of its bond portfolio but what they have done is to stop fresh purchases of bonds. Rollover of bonds is happening and that is the reason the US bond portfolio has been almost static. But all that could change in the next couple of months as the Fed embarks on a tapering program. To begin with, the Fed will tart tapering the bond portfolio by selling these securities back to the institutions. At the same time, the ECB also plans to reduce its monthly bond buying by 50% from Euro 60 billion per month to just Euro 30 billion. What the bond purchases will continue, the volume will be much smaller. BOJ and the Band of England may follow suit sooner rather than later.

What it means for liquidity…

There are 3 reasons it could be a worry. The entire equity and bond rally post 2008 was driven by this easy liquidity. That could start reversing with FPIs preferring a risk-off trade. Secondly, we have seen in 2013 and in early 2016 that negative liquidity shock expectations can be quite vicious. Lastly, tighter liquidity will mean higher yields on bonds and that will have an impact on equity demand as well as on cost of capital. The big risk in the coming year could that this liquidity reversal could spook markets. Watch out for liquidity in 2018. ©

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