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Entries in liquidity (5)


Liquidity squeeze in corporate bond markets

We have had the the discussion for while on the adverse effect from Fed policy on the supply and liquidity of fixed income securities. This is relevant both in terms of the outright supply of assets in terms of portfolio composition needs as well as the use of such assets as collateral

This is a theme Variant Perception has covered in detail this year and in a recent blog, we look at the increasingly disappearing liquidity from corporate bond markets

One of the themes that we have been highlighting this year is the growing bubble in corporate bonds. It is pointless in the first instance to discuss whether super easy monetary policy that has fueled this bubble is appropriate or not. The main thing for investors to countenance is that the current monetary policy regime is having unintended consequences through the formation of a bubble in increasingly scarce liquid fixed income instruments.

In May, when we put out our report on corporate bonds, we described what we saw as the seeds of the next global crisis.  In particular we emphasized the fact that there are now more corporate bonds outstanding in the US than there are mortgage-backed securities.  That chart remains a key chart five months hence.



The Curious Case Of Liquidity Traps And Missing Collateral - Part 2 

In this second part of my take on liquidity traps and missing collateral in global financial markets I would like to respond to some of the talking points set out by FT Alphaville's Cardiff Garcia (again in response to the much talked about piece by Credit Suisse). Even though blog posts tend to age quickly, recent central bank action suggests that this topic is relevant as ever. Specifically, negative readings across a wide range of short term interest rates in Europe has raised the question not only what the effect of such abnormal interest rates are, but also whether such market prices are sending a signal to central banks that they ought to act much more aggressively. 

Following up on FT Alphaville's coverage, one question that is intereting to consider is the following. 

2) The movement of M1 and M2 in recent years seems not to have told us anything helpful about inflationary prospects. Should the Fed finally ditch them and start concentrating on another measure, perhaps one that incorporates some of the items above? Or bring back M3 (which at least included such shadow banking elements as institutional money market funds and repo)?

Initially, I should point out that I disagree with the premise of this statement. I think that there are still important effects from fluctuations in M1 and M2. Specifically, I believe that while being in structural process of deleveraging may certainly mitigate the inflationary pressures from central banks generating excess reserves (and liquidity) in the system, it is dangerous to assume that expanding base money does not have a real economic effect. 

Still, this raises a very important point. The traditional monetary policy transmission mechanism is broken and as a result the size and expansion of base money aggregates have little bearing on credit creation in the real economy. The key question is the whether central banks should extend their control of the money supply further down the credit foodchain (i.e. closer to the end user/beneficiary of the credit)? And if you answer to this is yes, how do central banks do this most effectively. 

Firstly, it is important to emphasize that, in many ways, they already have. Initial responses to the crisis in the US (and QE conducted by the BOJ) have been engaged in strategic and direct purchases of several kinds of marketable debt and equity securities, but central banks generally do not like to do that. Historically, the Bank of Japan has been most direct trying to influence market prices through the purchase of corporate bonds and exchange traded funds. 

Now however, they are at it again of course. The BOE recently suggested open market operations with strings attached in the form of banks only getting access if they added to their balance sheet and in Europe, the ECB has cut its deposit rate to 0% and may even push it into negative this week. 

The problem however is that it is very complicated for the central bank to do this effectively and a central bank will always be adverse to taking direct market risk (even if e.g. the allegedly most conservative central banks of them all, the ECB, has taken substantial market risks through the collateralised LTROs). In addition, targeting M3, M4 etc would mean an even more direct involvement in the credit process by which the central bank potentially acted as direct underwriter for pools of securitised loans of all shapes and sizes. This adds illiquidity to the balance sheet and exposes the central bank to significant mark to market risks which eventually may have to be covered by printing money. Such an implicit backstop to securities that the central bank may agree to buy creates significant moral hazard. 

But it is certainly a fair question to ask whether central banks have been using the wrong tools as e.g. Izabella suggests in her coverage of the concept of the negative money multiplier

Traditionally, a central bank will respond to a liquidity trap by supplying (potentially) unlimited levels of excess reserves to the banking system and thereby expanding the potential credit supply in the economy. The counterbalancing asset side entry here will usually be short term government bonds but also, if need be, longer term government securities. In this sense, expanding the balance sheet at the zero bound is essentially a fiscal expansion. However, as Izabella suggests, this may actually be counterproductive in an economy suffering from a structural lack of liquid and investment grade collateral. 

The central bank will then actually exacerbate the lack of such assets by doing textbook QE which involves creating bank reserves in exchange for short term government securities. Demand for government securities (collateral), the story goes, would be more than enough to keep yields down and allow the government to conduct fiscal expansion at the zero bound. Still though, one would have to assume a complete lack of any market response from bond vigilantes ad infinity for this to work. I am not sure that I accept this. 

So where does a broader monetary aggregate target come in? Well, from the account above the central bank could do two things. 

1. Act on the liability side by aggressively cutting excess reserve requirement and enforcing a penalising rate on excess reserves. This would be a direct way (through the liability side) to attempt to jump start the money multiplier and force up velocity, but it will require the central bank to be indifferent between currency and reserves on its liability side (see below). 

2. Avoid crowding out demand for safe collateral by booking anything but government securities on the asset side. 

On the second point, I would note that this assumes a complete lack of bond vigilantes of any kind and thus no disciplinary market action in the context of financial repression. In the context of structurally overlevered governments across the developed world, I am not sure that this is a reasonable assumption over time. What would Gilts be trading at if the BOE was not holding 30% of the total stock outstanding and how would this have affected the government's ability to borrow. In addition, taking direct market risk by e.g. purchasing pre-assigned tranches of securitised loans (to beef up broader monetary aggregates) would certainly not work if the underlying problem was one of a structural lack of solvent credit demand. I have argued for example that this is a major part of the problem both in the context of private and public borrowers. 

On the first point, events have caught up with theorizing here with the ECB the first major central bank now imposing zero interest rates on its deposit rate (the Riksbank did this in 2008/09 too) and there is a serious probability that the rate may be moved into negative. 

I have been lucky to have the opportunity to discuss this with the financial columnist and investor Sean Corrigan who makes the following crucial point. 

People are treating this [negative deposit rates] in a completely erroneous fashion.  Even negative rates cannot force the banks to lend out the deposits they hold at the central bank; this is to assume they - as a whole - have choice in the matter: they do not. If the central bank creates what is called 'outside' money, by buying securities, etc, the corresponding reserves cannot be voluntarily removed: they have to be held as CB liabs/commercial bank assets on the central bank balance sheet.


What such a move could possibly do is to make it more imperative for banks to leverage up by creating new, extra loans (To whom? On what terms?) and to accept new customer depo's (given that they hold a huge surfeit of reserves on their balance sheets with which to backstop these) and so compensate for the negative rate drain by the volume effect. I take this as dubious, however, given normal credit concerns and, in some cases, binding capital constraints.

Sean then goes on to make the final point that if the central imposes negative interest rate on reserves while at the same time wanting to maintain the size of its balance sheet, it would have to generate currency as reserves were withdrawn. 

I think a couple of points are important to note at the offset.

The situation at the ECB and the Fed/BOE is different. More specifically, reserves created in the Fed/BOE is, as Sean points out, "outside money" and is thus what we could call "push QE". The central bank has a policy objective to affect government bond yields and the only way it can do this is to generate reserves in the system. At the ECB and while the central bank may certainly have intended to affect government bond yields in the periphery this was "pull QE"; i.e. reserves were pulled from the ECB based on banks' demand for such liquidity and, presumably, their need to shed themselves for collateral.

One of the main objectives as stated by the ECB was to provide liquidity to banks who could not otherwise refinance themselves in the short term money market. I think it is critical here to note that while the Fed and the BOE have always put forward specific targets for their QE operations, the ECB has not! If the banks had put up 2 trillion worth of collateral in the LTRO and asked for 2 trillion in liquidity they would have gotten it! 

Anyway, to the point that banks are forced to hold these reserves (as a counterpart to the size of the balance sheet), in the perfect world it is not certain that this is the case. Let us assume a central bank conducts QE through the expansion of reserves with two objectives in mind.

1) To affect government bond yields (perhaps to allow the sovereign to run higher cyclical deficits for a period to boost aggregate demand).

2) To improve risk sentiment and risk taking in the economy through higher credit creation by commercial banks. 

One immediate effect of such a policy in an environment where the monetary policy transmission is broken is that while government bond yields may go to zero it has no effect on lending to the real economy.

What can the central bank do? Not a whole lot as it were. 

The central bank created the reserves in the first place and cannot easily induce banks to lend these out without compromising its asset side. In other words, it is difficult to pursue both objectives directly at the same time.

Specifically, if banks started to draw on its excess reserves to lend out to the real economy the central bank would need to one of two things. Maintain the size of its balance sheet constant by creating currency or reducing its holdings of securities on the asset side (government bonds). The latter is difficult to do especially if the central bank has been very aggressive in its sovereing bond purchases. Still, theoretically the central bank will be informed by the notion that the economic multiplier of commercial banks lending out to the real economy is higher than central bank financed government spending. It is not inconceivable that this is what central banks may start trying to do. We are seeing this by the BOE now giving preferential treatment to banks lending out and the ECB with its latest move.

Finally, negative rates could, as noted above, force banks to lever up to make money and it is not inconceivable that this could work in some countries where the banking system sounder or where some banks may have the buffer to do so. The main risk for the central bank is that this reduction in its balance sheet simply forces reserves into government bonds anyway as commercial banks see no other choice. The structural features of financial repression also will point towards this.

Here of course, the practicality becomes an issue. The BOE now holds 30% of all Gilts outstanding and if it started to sell these off as banks started to lend to the real economy interest rates across all maturities and lending products could rise very fast and in complete disconnection with underlying fundamentals. Currently, the position for central banks in this matter is complicated because as we have seen liabilities tend to migrate to the government balance sheet and as such the central bank needs to work very hard to keep borrowing costs in check for the sovereign.

Now, as for creating physical currency it is not clear to me that central banks would want to do this but the notes that I have read so far simply assume that it is given that commercial banks would be able to shift reserves into currency. This then brings up a whole hosts of other issues regarding the existence of cash at the zero lower bound. Citi's chief economist Wilhelm Buiter for example has suggested that physical currency be retired altogether and that electronic money be used instead. Such electronic money could of course be subject to exactly the level of negative interest rates the central bank deemed fit or perhaps even be subject to a fixed maturity.

Negative deposit rates have another effect in so far as they induce carry trades in with the negative currency yielder as funder and thus pushes the currency (euro) down. Such real effective depreciation could be a powerful tool for the ECB and for once it is a first mover here. 

Ultimately, negative deposit rates are no panacea and certainly in the context of central bank creating the excess reserves in the first place, but the effect of FX markets as well as the potential for its effect on the quantity of currency in the system should be keenly watched. 


The Curious Case of Liquidity Traps and Missing Collateral - Part 1 

The debate is on! Are we in a liquidity trap and if so what should we do? Why is the financial system depleted of collateral and what does this mean? Should policy makers and central banks be even more "irresponsible" [1] and conduct more monitised deficit spending? What does a lack of triple A rated/safe haven securities mean and is it real? 

All these questions and more have recently gotten a fascinating treatment in the economics debate courtesy, mainly, of this piece by Credit Suisse.  FT Alphaville has been given the question extensive and brilliant coverage and now even the IMF has pitched in. I think the issues raised are not only important, but likely to form a substantial part of the framework for the next decade's research on macroeconomics, monetary policy and financial markets.

So yes my dear reader. This is no time to shy back. Dig in, and dig in hard! In this first post of a series of 3-5 posts, I try to present the building blocks of the argument as I see them and answer the question of why the traditional view on the liquidity trap does not apply in the current situation. 

Let me begin with the following key premises for my argument and the state of the global economy and financial system post 2008/09. I will try to develop each of these statements in the posts that follows. 


  • The crisis of 2008/09 has ushered in what is likely to be a period of severe stress in global sovereign fixed income markets. Sovereign debt distress and defaults are messy and costly affairs and take a long time to deal with. We have now entered a period where the next 10-20 years will see several developed economies default on their sovereign debt. Ageing populations, too low growth and insufficient future income/consumption to push forward mean that the OECD is now at an inflection point. For global financial markets this means that an unprecedented and systemic share of the global fixed income market is likely to be in distress at any given point in time over the next 10-20 years. 
  • There is an accute shortage of liquid triple A rated government securities. This shortage is structural and capital deepening in emerging economies is too slow and insufficient in size to take up the slack. Pension funds, insurance companies and big real money managagers are now essentially unable to construct their portfolios in such a way to match their future liabilities with a satisfactory (or perhaps even promised) yield. In addition, this leads to mispricings in remaining assets considered the last safe havens. US government bonds, UK Gilts, German Bunds, Danish Mortage Backed Securities etc. 
  • Central banks are now acting as international clearing houses for the banking system. This is mainly seen in Europe where the ECB has been forced into taking up slack for an interbank market which has essentially been broken. Lowering of collateral standards, ever higher portions of liquidity and extension of maturities of its open market operations are all signs that the ECB is now effectively not only acting as the lender of last resort, it is de-facto the vehicle through which European banks can access liquidity across all maturities. However, whether the central banks buys government bonds outright or funnels demand through the banking system amounts to the same thing. 
  • The demand for credit is as much a propblem as is the supply. Sifting through the references below, you will find that at least one solution to the problem is that governments must issue even more impaired debt instruments which essentially become assets backed by liabilities created by the central bank. We must understand however that the core of the problem is that there is now a structural lack of solvent sovereign and private credit demand. The argument goes that the higher demand for safe haven triple A rated assets must be met with supply by sovereign debt issuers, but the ability of governments to issue such securities is structurally impaired. 
  • Central bank monetisation of government liabilities either outright or through open market operations providing liquidity to banks are not costless, even in a liquidity trap. Macroeconomic theory is currently informed by the notion that creating unlimited amount of excess bank reserves in the presence of a liquidity trap (zero velocity environment) has no malicious inflationary side effects. I think the evidence from more than three years of monetary experiment among the major central banks forces us to re-visit this conclusion. 


The Liquidity Trap Revisited

In order to start somewhere, I will begin with Izabella's exposé on this paper by Paul McCulley and Zoltan Pozsar. The main points from Monsieurs McCulley and Pozsar's paper, with some slicing and dicing of quotes, are as follows. 

At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.


... the operational mandate of a central bank operating in a liquidity trap environment should be changed materially.Rather than “policing the government to keep it from borrowing too much” the central bank should help it “to borrow and invest by targeting to keep long-term interest rates low by monetizing debt, with the aim of killing the fat tail risks of deflation and depression. ”The interests of the fiscal authority and the monetary authority rightfully become entwined. What’s more, the loss of the central bank’s independence should not be seen as a concern.


Critics invoke the orthodoxy that printing money is inflationary. But in a liquidity trap it is not. Money is as money does, and judging from the trillions in excess reserves on banks’ balance sheets, money isn’t doing anything. Printed money is unlikely to become inflationary until after the private sector has finished deleveraging and is bidding for funds again.

Generally, I find it difficult to see what new McCulley and Pozsar brings to the table here. This is liquidity trap and deleveraging economics 1.0, but I feel that we need a version 2.0 to understand what is really going on. The liquidity trap argument of old rightly emphasize that government should weigh against a necessary private deleveraging by running large and perhaps even, on the face of it, irresponsible deficits. This line of argument was, in part, inspired by the Japanese experience and the widely held perception that the BOJ was too timid in the initial phases of the Japanese bust.

I largely agree with this line of argumentation, but if the sovereign is an intrinsic part of the problem the argument breaks down. The problem today consequently runs a step deeper than the original liquidity trap argument.

While the initial symptoms of the financial crisis were rightly identified as too much private debt and reckless credit expansion in a key sector (housing and construction) the subsequent crisis in the euro zone has exposed two additional and critical aspects of the crisis.

Firstly, we have seen how governments will ultimately end up assuming private liabilities onto their balance sheet. Secondly, issues of fiscal sustainability in the OECD have been known for ages, but now time has run out. In my opinion, the crisis has provided a catalyst for the unravelling of the obvious mismatch between governments' pension and health care promises to their populations and the inability to meet such promises due to ageing population and low growth environments. 

If you accept my premise that sovereign debt sustainability is now a systemic part of global financial markets, you will also see that they role they are supposed to fulfill according to the original views on the liquidity trap becomes very difficult. 

Arguing that sovereigns should ramp up the supply of government debt and that central banks should add to the demand for such debt by creating money represents a misinterpretation of the problem. While it may surely mask the underlying issues for a while it cannot hide the fact that we are now at a crucial inflection point in the developed world. OECD governments' business model is broken due to population ageing and future liabilities which they will not be able to pay off. 

The financial system's ability to create highly liquid and safe fixed income securities depends on current and future income to service such liabilities and traditional suppliers of such safe assets are simply out of time. Asking governments to act as counterweights against private deleveraging by creating even larger quantities of unserviceable debt cannot work. We see this most forcefully in Europe where sovereigns are being brutally cut out of the market, but there is, in principal, not much difference across the entire OECD spectrum.

It is my view then that for such highly liquid and risk free securities to survive and be continuingly issued, in the current environment, central banks must become permanent supporters of their issuance. We may certainly come to the conclusion that this is a warranted use of central banks' power, but we should be under no illusion that their involvement on this will be, on any plausible definition, temporary. I think this part of the equation has been given far too little credence in the debate so far.

In conclusion, while I agree that LTROs and central bank bank monitisation of sovereign debt liabilities may certainly be warranted from the point of view of battling a severe crisis the way out of this one cannot be mapped exclusively through the lense of ongoing central bank liquidity provision and reserve creation. 

Once you accept this part of the argument, we are ready to move on to the issue of what such substantial central bank involvement in our economy means and and also why the collateral crunch is likely to continue and what it means.

Stay tuned ...  


[1] - My readers who are well versed in the research on deleveraging, liquidity traps etc will understand the reference here. In the original literature and thinking about zero nominal interest rate bounds and liquidity traps, the central bank's ability to act irresponsibly is seen as a key prerequisite for turning the corner on debt deflation.