Out Of The 'Liquidity Trap' Frying Pan And Into The 'Liquidity Lure' Fire
Via Citi's Credit Strategy team
"Liquidity trap" was a term coined by John Maynard Keynes in the aftermath of the Great Depression. He argued that when yields are low enough, expanding money supply won't stimulate growth because bonds and cash are already near-equivalents when bonds pay (almost) no interest. Some would say that it is a pretty apt description of the state of play these days.
However, most economists today would contend that monetary policy doesn't just impact the economy through interest rates, but also through other several channels, one of which is asset prices.
To our minds, there is very little doubt that central banks have played an absolutely crucial role in propping up asset prices in recent years. We'll leave the debate about the link between asset prices and growth for another day, but we do believe that in so doing they have prevented a much faster and more vicious deleveraging process.
Just look at Figure 2 below, which compares the 3-month change in liquidity provided by the central banks with the 3-month change in global equity markets. We could have used credit spreads instead and it would have made very little difference. Every time the central banks have injected liquidity, markets have responded, although recently most of the response has been preemptive.
Why have markets responded so resolutely when growth hasn't?
The answer, we think, is that in their attempts to free markets from the liquidity trap, central banks are ensnaring markets in what we'll call a "liquidity lure". That lure is three pronged:
- By lowering rates to zero (and potentially promising to keep them there), central banks are forcing money out of money markets and deposits into riskier assets for higher returns. In corporate credit, the corollary has been almost continuous inflows since late 2008.
- Through balance sheet expansion – that is buying assets or funding them for a long period of time without rehypothecating them (lending them out) – the central bank is shrinking the universe of investable assets in the market. The red line in Figure 3 below, which shows the net issuance of securities in Europe on a rolling 12-month basis after the effect of long-term ECB repo operations, clearly illustrates the point.
- Lastly, through the signalling value. By sending an implicit message to markets that the central bank is intent on supporting asset valuations, perceptions of risk/reward change – it is much more uncomfortable to be underweight/short unless there is a specific, tangible negative catalyst.
In the initial phases, strong asset returns make the lure too enticing to resist – who would have predicted that investment grade credit would generate total returns of 10.5% in 2012?
Yet the catch is equally obvious: When the returns have been had, investors end up with a distorted trade-off between risk premia and fundamentals. Or more bluntly, swamped with cash and faced with fewer assets on offer, investors end up buying assets at levels where they don't perceive they are being fully compensated for the risks they are ultimately running. From that position, there is no painless escape.
Conclusion: Hooked until it snaps again
Central banks, especially when they are acting in coordinated fashion, have the ability to create an equilibrium for asset prices and credit risk premia that differs markedly from the 'natural' state – at least temporarily. The credit market is just a microcosm of that broader story.
Quite simply, they will (indirectly) keep investor pockets filled with cash, whilst restricting the volume of assets for sale. Remember how tight credit spreads got in the middle of an extended recession and deflationary environment in Japan?
But Europe is evidently not Japan. Many sovereigns today do not have the "luxury" of a big current account surplus and the ability to run large fiscal deficits for more than a decade as Japan did. Tail risks, be it Grexit, Catalan independence, Italian elections or "just" popular unrest, are bound to resurface in our view.