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Out Of The 'Liquidity Trap' Frying Pan And Into The 'Liquidity Lure' Fire

Tyler Durden's picture




 

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:

  1. 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.
  2. 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.
  3. 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.

 

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Sun, 10/14/2012 - 21:17 | 2888988 DoChenRollingBearing
DoChenRollingBearing's picture

Lots of risk everywhere, we all know that.  Even the mainstream publication of Wall St. knows...

Review of Barron's -- Dated 15 October 2012:

 

http://tinyurl.com/97mtev5

Sun, 10/14/2012 - 21:35 | 2889005 Newsboy
Newsboy's picture

Cash out now.

Build a "lifeboat".

Or at least buy the dip in gold after the election, when the bad stuff that's been on hold for so long has to be faced.

Sun, 10/14/2012 - 21:20 | 2888993 Boilermaker
Boilermaker's picture

Yes, yes...all that shit.

Or, whatever else or whatever.

Sun, 10/14/2012 - 21:30 | 2889002 knukles
knukles's picture

The operative consideration is to what the Adjusted Monetary Base is being applied by the banking system.

In ordinary times the system is usually operating at a level somewhere close to the capacity of the Reserve Base so to speak.  As Reserves increase or decrease there is a general concomitant reflection in the outstanding bank loan balance ....  Oversimplified but nonetheless reasonable for this purpose.

In today's environment, that of a Liquidity Trap, Reserves are not being applied to loans but to temporary types of investments.... bonds, deposits at the FED, etc.  As such, any leveling off or even contraction of the Base is absorbed within the FED deposit or other investment categories and as such does not impact outstanding Loans for which there is No Demand.

Under such conditions, the Monetary Base can contract and resultant deposit/loan activities which are not impacted have no resultant impact on economic activity, just as the QE's have had none on the upside.

QED

At this time, not a worry....
However, once Velocity rebounds with excess reserves in the system.... Gonna be a big problem.  And in the mean time, the impact of excess monetary expansion not translated into Real GDP is on the general level of prices (Inflation) for the portion of the monetary growth not absorbed by declines in Velocity.

It's all the effect of a liquidity Trap caused by a Credibility Trap... which is behavioral.  Meaning that meaningful economic activity will not increase until some reasonable change in the DC/banking/legislative/lawlessness environment is addressed... good luck and don't hold your breath.

reply

Sun, 10/14/2012 - 21:34 | 2889004 Boilermaker
Boilermaker's picture

Yea, yea...that too.  That's what I meant to say in addition to whatever was already said.

Sun, 10/14/2012 - 21:38 | 2889010 narnia
narnia's picture

Governments around the world are racking up loads of Soviet style collateral-less promises.  Central banks are making a market in this junk until they can't.  Why complicate the explanation?

Sun, 10/14/2012 - 21:46 | 2889016 Boilermaker
Boilermaker's picture

Exactly!  That's basically what I was almost thinking also.  The 'Soviet style' part, particularly...that was awesome.  Forget all that earlier non-sense. 

Sun, 10/14/2012 - 21:49 | 2889029 cosmictrainwreck
cosmictrainwreck's picture

you kill me, man......

Sun, 10/14/2012 - 21:58 | 2889041 max2205
max2205's picture

I don't think any asset will survive the next leg down. Nope not that as well

Sun, 10/14/2012 - 23:20 | 2889129 RiverRoad
RiverRoad's picture

max 2205:

Quite true when the common denominator is reducing.

Sun, 10/14/2012 - 22:08 | 2889045 jwthomps
jwthomps's picture

Nice post, I like your points.

Do you think Fed policy works again, or is this the time it fails?

Sun, 10/14/2012 - 22:20 | 2889060 ekm
ekm's picture

In theory government buying assets can continue until the gov buys all means of production. It's called communism. Remember, stock market is 11 times smaller than the bond market.

 

The more it continues, the smaller the market becomes, the more wall street has to lay off people.

Sun, 10/14/2012 - 23:11 | 2889064 Mercury
Mercury's picture

…it is much more uncomfortable to be underweight/short unless there is a specific, tangible negative catalyst.

 Such as acute viral coffee aroma awareness?

 

Quite simply, they will (indirectly) keep investor pockets filled with cash, whilst restricting the volume of assets for sale.

...thus making hard assets more attractive by so doing.

Sun, 10/14/2012 - 22:35 | 2889080 Caviar Emptor
Caviar Emptor's picture

If you assume that asset prices such as equities have risen out of "wise investment choice" given today's market realities you are wrong. Those were the marching orders of the Central Bank to the banks and WS in exchange for handing over essentially free money via the QEs, bailouts of various kinds and the ZIRP deal whereby banks borrow at zero and lend back to the Treasury at higher interest. 

The only big particpants are the banks. They have learned through the experience of 1987, 1998 (LTCM and its market plunge), 2001 and 2008-9 that they just need to stamp their feet a bit and the Fed will fire up the helicopters and make good on their put (Cramer's rant was a good example that the public got to actually see). 

The main agenda of the Fed is keeping the failed banks afloat. The by-product is biflation. That's why we have no hyperinflation because of the deflationary forces still actively at work in the economy pulling in the opposite direction by lowering end-demand and causing wage-deflation. And that is why asset inflation in paper assets such as equities is just a bubble. 

Sun, 10/14/2012 - 23:17 | 2889126 RiverRoad
RiverRoad's picture

Caviar Emptor:

You nailed that one.  But I must add that "growing jobs" is pure lip-service from the Fed.  The last thing they want is full employment with the velocity of money and inflation taking off like a rocket.

Sun, 10/14/2012 - 23:45 | 2889150 Ungaro
Ungaro's picture

Monetarists attempt to repeal the fundamental laws of economics. You can inject all the liquidity into a contracting economy (falling aggregate demand) and it will not move the needle. Once deflation brings prices into an equilibrium with personal disposable income, aggregate demand will pick up.

Politicians and governments cannot "create jobs"; jobs are created when demand grows. Saying that you want to create jobs will not make it so and neither will tinkering with the tax code, protectionism, or government subsidies.

There are some pretty good models of how to create a vibrant economy: honest money (no fictional reserve banking), extremely limited government borrowing, small government devoid of corruption, a fair and exquitable yet simple tax policy, no military entaglements, and investments focused on domestic issues: education, infrastructure, energy, law enforcement and jurisprudence, healthcare, and the environment. Check out how Singapore is doing, or Luxemburg by way of some examples.

Mon, 10/15/2012 - 00:04 | 2889162 RichardP
RichardP's picture

... jobs are created when demand grows.

As was pointed out and argued on a recent thread - yup, that's the way we got iPhones.  Everybody demanded them, so Apple went out and hired a bunch of folks in China to build them.  Or not.

I think the Apple model is the way jobs in furniture factories grew also after WWII.  The owners of the means of production went out and built a lot of furniture factories and turned out a huge supply of various types of furniture (just like Apple did with the iPhone).  This caused people to get married and make babies and set up households and scoop up all that furniture that was there waiting for them.  Or not.

Maybe the relationship between jobs and production and demand is more variable and complicated than one simple model can ... model.

Mon, 10/15/2012 - 01:11 | 2889230 tom
tom's picture

Funny that Citi guys apparently don't bother to read Keynes. He never used the term liquidity trap and he never made the argument Citi is attributing to him.

Keynes wrote that if a central bank were very aggressive in lowering long term rates it could result in investors preferring cash due to the low reward for risk. Hicks called that situation the liquidity trap.

The argument that Citi is attributing to Keynes concerns short rates and is actually from a paper by Krugman about Japan.

Try reading. It's not so hard.

Mon, 10/15/2012 - 02:05 | 2889254 ebworthen
ebworthen's picture

Um...you really can't have meaningful growth without meaningful career employment.

The FED buying MBS's and the other QE does nothing for employment, but they know that.

Mon, 10/15/2012 - 14:32 | 2889857 Sandmann
Sandmann's picture

That's a very fair assessment of Keynes' position, tom. The fact remains that Central Banks are twisting Yield Curves buy redeeming Bonds for Cash and lowering them right across the spectrum so Cash almost has a positive yield - more realistically a lower probability of negative yield/capital loss than a Bond because of its fungibility. The Central Banks are destroying The Future because they are resolving all but the most speculative asset classes to Cash held for the Precautionary Motive.

Keynes' real innovation was Uncertainty and he wanted Government to inject Certainty where Central Banks toyed with mmonetary policy and created Stasis. We now have a disastrous policy outcome of Stagflation with no end in sight but the whole economic model being used to prop up the balance sheet of zombie banks. The global economic system will collapse into trading blocks using block currencies and closed economic zones. Central Banks have failed the Citizenry by serving the interests of the Banks as Governments have extracted real incomes and capital from the Citizenry

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