Peak Liquidity Portends Trouble for Risk Assets

Liquidity, Liquidity, LiquidityAmid all the excitement and confusion of the last two years, the ascent of the stock market, and the continue
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Liquidity, Liquidity, Liquidity

Amid all the excitement and confusion of the last two years, the ascent of the stock market, and the continued robust health of other asset classes, has boiled down to three words: liquidity, liquidity, liquidity.

While money in its most liquid form continues to be so freely available, it’s harder for bad things to happen to risk assets. There really is no alternative if bonds are being bought up swiftly and turned into cash that needs a home. But that raises a number of issues. How do we define liquidity? How do we know when it is diminishing? And what happens when it is finally removed?

Crossborder Capital Ltd. of London keeps widely followed indexes that track year-on-year changes in the monetary base. Over the last six months, growth has gone from exceptional to merely very high. By Crossborder’s calculations, major central bank liquidity is growing at less than 10% now. The Federal Reserve has already announced that it is tapering support for bond markets, and seems to mean it. One glaring exception is the Bank of England, which has reopened the tap just as it was expected to start raising rates:

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To the extent that liquidity growth drives the economy, the numbers tell much the same story as economic surprise indexes and the Treasury market. Reducing liquidity, falling nominal yields, and a petering out of positive economic surprises are all consistent with economic growth fading and potentially a tough time for risk assets:

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Meanwhile, Crossborder’s measure of emerging market liquidity, which tends to be highly cyclical, is showing signs of peaking and beginning to decline, to a great extent because of the People’s Bank of China, which is trying to damp speculation in the property market:

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So the liquidity indicators tell a broadly consistent story. Emerging markets are under greater pressure to tighten because they have greater propensity for inflation. The virus is stopping central banks across the world from removing liquidity too rapidly. And their moves to avert overheating should logically be expected to slow economies. 

But if this interpretation is right, the equity market hasn’t got the lesson yet. As BofA Securities Inc. points out, on a rolling 10-year basis, equities are beating bonds in the U.S. by the most since 1964:

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And why is liquidity tightening up so much when central banks around the world are mostly not yet in tightening mode? 

One answer is the dollar. It continues to be the global reserve currency. A stronger dollar reduces the buying power of liquidity available in other currencies. When the dollar appreciates, global liquidity tends to tighten. When other central banks try to hold out and say they are going to stay easier for longer (the current policy of the European Central Bank), but investors believe the Fed when it says it is going to tighten, that attracts liquidity to the dollar and, at the margin, tightens liquidity for everyone. That is what is happening. After a wide round trip, the dollar is now worth almost exactly what it was at the beginning of last year, before the pandemic. This is true whether you use the dollar index, comparing to major currencies, or the Bloomberg dollar index, which also includes major emerging currencies: 

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Meanwhile inflation is a real problem, beginning to have serious impacts on consumers’ confidence. So how can risk assets still be so confidently aloft? 

Here we need to remember that when inflation rises, the gap between real and nominal measures tends to widen, and it becomes more important to track the real numbers. After all, real and not nominal yields are what central banks try to influence. And real yields are shockingly low. I’ve offered various illustrations of this in recent weeks. Here is a good chart of the real U.S. 10-year yield from BofA, going back to when Alexander Hamilton was running the Treasury department:

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It’s slightly reassuring that there are many precedents for negative 10-year real yields. It’s less reassuring to see that they were all associated with times of war, or serious financial crises. The progress of real yields over the last year is also strange. They have been thoroughly dull, and locked in deeply negative territory. You’d expect tightening liquidity to force them up. It hasn’t happened, yet:

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It’s hard to explain this. The persistence of low real yields may be the central market conundrum of our time. Will Denyer of Gavekal Research put the issue beautifully. Every stage of his bond market forecast for 2021 has worked out, except the last:

  1. U.S. inflation would accelerate (check).
  2. Accelerating inflation along with economic reopening would cause a rebound in nominal yields back toward pre-Covid levels (check).
  3. Inflation expectations would start to test the high end of their recent range, at around 2.5% for the 10-year TIPS breakeven rate. When they did, the Federal Reserve would start talking about tightening (check).
  4. This tightening-talk would undermine beliefs that the Fed would stay loose forever and would encourage a rebound in real yields (oops…).

His prediction, and thought process, exactly matched mine. So why won’t real yields budge? Denyer’s summary:

(i) a moderation in new issuance by the Treasury,
(ii) the prospect that commercial banks may take over from the Fed as creators of credit,
(iii) concerns that the Fed will remain behind the curve on inflation, and
(iv) expectations that financial repression will keep Treasuries well bid.


This makes sense up to a point — particularly the idea that financial repression is ahead. But commercial banks might need more generous yields before taking over the Fed’s role. The central bank looks ready to act — and might have to even quicker if the market tries to test a new Chairwoman Brainard. Indeed, if we use real rather than nominal yields, it’s questionable whether the market thinks the Fed is behind the curve at all. The real yield curve, comparing yields on two- and 10-year Treasury inflation-protected securities, has steepened recently, even as the nominal curve has flattened:

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As Tan Kai Xian, also of Gavekal, explains, the Fed is trying to influence real yields. If the real yield curve is steepening, it shows the market sees monetary policy continuing to get tighter into the distant future. That implies less worry about a slowdown in our near future, and suggests that the Fed isn’t behind the curve. It would be nice if the bond market were right about this. 

Where does this leave us? The abundant global liquidity that has stoked a rally for the ages in risk assets is endangered, by the strengthening dollar and by the need to do something to counteract inflationary pressures. Obstinately low real yields help to explain why the threat to liquidity has as yet had minimal effect on the stock market. Higher real yields are the shoe that hasn’t dropped this year; investors need a clear plan of evasive action for such an eventuality. For now, liquidity, liquidity, liquidity is still keeping stocks going up, up, up.

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Ones, Tooze and PAWZ

This is your reminder that the last book club selection for the year is Shutdown by Adam Tooze, his attempt to write a first draft of the economic history of the pandemic. We will need to wait many years for a definitive judgment. But Shutdown is admirably comprehensive and clear, and makes a great framework to sort out ideas. 

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A brief reminder: This is a book “club” in the loose sense of Oprah Winfrey. There’s no fee or membership. Every month I nominate a book for people to read, and a month later we have an online discussion about it, ideally with the author. If this sounds interesting, get hold of a copy and read it over the next month.

Tooze, a history professor at Columbia University in New York, is incredibly prolific. You can find his podcast, Ones & Tooze, produced with Foreign Policy, here. It covers a lot of themes that will be familiar from Points of Return. He also now has a Substack newsletter, Chartbook, which is endlessly informative.

The latest installment goes into great detail on his experience as a dog-owner during the pandemic, and the remarkable history of the Havanese, his dog’s breed. Havanese turned up in paintings by Goya and Titian before they became popular among the wealthy gentry of Cuba, apparently.

Tooze also shares research from Morgan Stanley on the future of pet ownership, and hence the viability of the pet-care industry as an investment. Pet ownership in the U.S. is high:

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Only  a third of U.S. households is pet-less, a remarkable statistic. But there are big differences between cultures. A 2016 survey by consultancy GfK suggested that Latin Americans were the most enthusiastic pet-owners globally, while Asians were least keen. There were also big cultural differences in the preference for dogs or cats. Internationally, dogs are more popular, but there are several countries (notably France, Germany and Russia) where this is reversed.

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GfK also found bewildering cultural differences between countries when it came to choose what to feed your best friend:

Pets in the U.S., one of the biggest pet food markets in the world, are universally fed on a diet of chicken. Meanwhile, pets in Spain enjoy far greater variety with beef, fish and chicken flavored wet food and treats on the menu. French cats enjoy the gourmet reputation of their owners and, like Spanish pets, enjoy a variety of wet food and treats. However, when it comes to dry food, chicken dominates even in France. Consumers in the Czech Republic, Greece and China buck the tendency towards chicken, favoring beef flavored wet food for their dogs.

There is also a move toward fewer, natural ingredients, and selling in smaller portions, suggesting that humans are taking the welfare of pets more seriously, and that city-dwellers are increasingly choosing smaller dogs. All these trends could make the business more profitable, but also suggest that it’s easy to go wrong. Meanwhile, the Bureau of Economic Analysis projects spending on pets will increase from here:

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Even the bear case implies that we have a great period of secular growth ahead. My concern would be that this is in the price. The FactSet Pet Care Index, which is based mostly on U.S stocks, far outperformed the S&P 500 last year, starting with the pandemic shutdown:

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The excitement appears to be over, judging by the exchange-traded fund based on the pet-care index (ticker symbol: PAWZ):

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If the pandemic permanently introduced a new share of the population to the joys of pet ownership, then there’s room for this to become a mega-trend. As it stands, it looks like a PAWZ pause that will last until we can be sure new pets aren’t going to be discarded.

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Survival Tips

Beware of using phrases that might be taken too literally, particularly by someone who isn’t a native speaker of your language.

I learned this the hard way when I was a reporter in Mexico, and wrote that the president, who was term-limited and whose party had taken a beating in the mid-terms, was a “lame duck.” That’s a standard political expression in Britain or the U.S. Translated into Spanish, it sounds like a bizarre insult. This turned into a minor diplomatic incident.

For another example, switch to Christine Lagarde. Many criticisms can be made of her long and remarkable career as French finance minister, head of the IMF, and now ECB president. Insufficient command of English isn’t among them. However, when trying to convince journalists that the ECB was prepared to keep monetary policy easy even as other central banks tightened, she said last month that “comparisons are… odious” when talking about different economies. I didn’t find her performance particularly convincing. Some commentators, however, seem to have found her choice of the word “odious” to be “astounding” and deliberately provocative.

There’s no reason why they should. The phrase “comparisons are odious” means “comparisons are inappropriate.” Its first recorded use was in the 13th century. It appears in Shakespeare, and has been used through the ages by writers as varied as John Donne and Jack Kerouac. A quick Google search reveals that Lagarde had herself used the phrase twice, in different contexts, in March and July of 2020. She seems to regard it as standard speech and inoffensive.

And yet, apparently, this was seen in some American quarters as an “incendiary” piece of French obstinacy. Be careful how you express yourself. Maybe you should just always assume that your listeners will take you as literally as Amelia Bedelia.

Have a good week everyone.

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