If You’re Talking About Liquidity, There’s a Problem

At the risk of oversimplifying, liquidity can be viewed as access to cash, which impacts the ease of trading in a certain market. It’s contentious, and experts we’ve spoken to over the past month have used different analogies, but liquidity is often likened to pipes. There isn’t just a single big one that we can turn on and off. They come in various sizes, some with stronger flows than others thereby affecting how influential they are. With pipes, if you’re talking about them at all, the chances are that something’s already gone wrong and you’re calling the plumber; the same is true of market liquidity.

Let’s first look at broadly defined money supply, or M2, the “pipe” that investors look at most. M2 measures M1 (currency and coins held by private banks, travelers’ checks, etc.), the money in US stocks, deposits under $100,000, and shares in retail money market mutual funds, according to the definition of the Federal Reserve Bank of St. Louis.

The following graph shows the year-on-year change, which has tumbled and gone negative for the first time since the series started in 1959. This explains why investors have been talking about a drain in liquidity:

US Money Supply Shrinks

Year-on-year M2 has declined since 2021 and turned negative for the first time

Source: Federal Reserve

But what matters most? Yes, the supply has shrunk over the last 12 months, but that’s after the massive increase in the early months of the pandemic. In total, M2 is still hovering near all-time highs. Should we care about the percentage flow, or the total amount or stock of money?

Rising US Money Supply

Cash, personal savings and market accounts hover near record-highs in 2023

Source: Federal Reserve

“If you widen your lens and aperture, and look at the dollars, the amount of money that’s in the system is still $4 trillion higher than it was pre-pandemic,’’ said George Mateyo, chief investment officer at Key Private Bank. “For that reason alone, I still think there’s a lot of liquidity in the system even though that the rate of change is slowing quite dramatically.” Strong spending numbers and the robust labor market suggest to him that any shortage of money is yet to have big macroeconomic effects.

Can this continue? Central banks around the world are trying to unwind their huge balance sheets. As they sell bonds — quantitative tightening (QT) in the jargon — money siphons out of the market. This, many in Wall Street expect, will hit risk assets and drive bond yields higher (just as building up the balance sheets in the first place pushed yields down). A June estimation by BNP Paribas SA predicted that a 10% contraction in global liquidity would correspond to a 4% decline in stocks, an appreciation of at least 2% for the greenback, and an initial jump of over 10 basis points for Treasury 10-year yields, as colleague Liz Capo McCormick reported. The firm’s strategists project liquidity to fall as much as 9% by the end of September and by up to 11% by year-end. At the extreme, a 16% contraction is possible.

But there’s been nothing like that effect. Risk assets are doing fine, with the S&P 500 up some 20% for the year and the Nasdaq roughly double that. Simply put, draining liquidity should be impacting markets, said Peter van Dooijeweert, head of multi-asset solutions at Man Group. So far, it has not:

A strong economy can trump liquidity issues after all. In spite of the liquidity withdrawal, equity markets have been relatively strong this year. When will QT start to bite? Last year, the markets went crazy over inflation and the pace of rate hikes while this year, QT continued, rates rose, but credit spreads tightened, bonds stayed stable, and equities have done well. Will that change as QT continues?

S&P 500 Fluctuates With The Stock Market Set For More Instability
Visitors at he ‘Fearless Girl’ statue outside the New York Stock Exchange.Photographer: Michael Nagle/Bloomberg

Raphael Thuin, head of capital markets strategies at Tikehau Capital, pointed to when the S&P 500 peaked in October 2007, just before the Global Financial Crisis:

Then what happened? What gave the market the final dive? A liquidity issue. And so liquidity can be the X factor. With higher rates and the shrinking of central banks’ balance sheets, liquidity is being drained out of the market, i.e. there is less cash available, financing and refinancing is more difficult to obtain and more expensive. Liquidity now has a price, and credit has value.

Other factors muddy the picture. To deal with the March banking crisis, the Fed put in place the Bank Term Funding Program to allow institutions to borrow against their holdings of bonds, as Points of Return discussed here — and that increased liquidity in the system. Coincidentally or otherwise, that was instantly followed by a sudden pop for artificial intelligence stocks and the market enjoyed a rally.

But money is fungible and easily crosses boundaries. Recent moves by the Bank of Japan and the People’s Bank of China to tighten liquidity have been a big deal beyond their shores.

Does It Matter?

Many, such as Goldman Sachs Group Inc.’s Manuel Abecasis don’t believe that declining growth in money supply is a leading indicator of a sharp decline in inflation or a recession. He wrote that monetary aggregates aren’t useful for economic forecasts, saying that “forces that have little effect on economic activity” have caused “large changes in the demand for reserves, cash, and deposits.”

The demand for reserves… at the Fed increased dramatically when the Fed changed its monetary policy implementation framework after the financial crisis, and the demand for cash and deposits has changed over time because of financial innovations like credit cards, changes in interest rates, regulatory changes, changes in the demand for US currency abroad, and changes in firms’ uncertainty over their short-term payment needs.

Dario Perkins of GlobalData TS Lombard argues that liquidity can’t explain market buoyancy, as there’s no stable relationship between asset prices and central banks’ balance sheets even during the era of quantitative easing. Changes in reserves at the Fed, European Central Bank and Bank of Japan combined prove to have been barely correlated at all with asset price swings:

Source: GlobalData TS Lombard

Liquidity, he made his point, is “BS,” and it has increased massively in this century:

Source: GlobalData TSLombard

There are middle grounds. Manulife Investment Management’s Frances Donald stresses that even if money is being sucked out of the system, not all liquidity has the same impact on the economy or markets:

There’s a sentiment element attached to liquidity. So, even seeing headlines that liquidity is improving can bolster sentiment. And the current market rally that we’re in is very sentiment driven. So to say that there is a mathematical connection between what’s happening to the Fed’s balance sheet and equities I think is oversimplifying story.

For others, liquidity drives everything. Mike Howell of Crossborder Capital, which publishes several indexes of global liquidity, says flatly that “if the money is anywhere, it has to be somewhere.” His measure bears out the contention that over time “bad things happen when liquidity tightens and global risk markets have duly wobbled”:

Source: Crossborder Capital

Even if last year’s contraction looks terrifying, it’s notable that liquidity has risen a bit in the past few months — and Crossborder thinks the low is in for this cycle. It found that global central-bank liquidity expanded by a “small” $58 billion in June, following May’s whopping $395 billion plunge. In nominal terms, the total is now $26.3 trillion. That’s below the Covid peak of $29.1 trillion in August 2021, but above last October’s $25.1 trillion as central banks tightened.

In July, developed world central banks did indeed withdraw $220 billion from money markets — but that was more than offset by a $278 billion injection by emerging market central banks. So far this month, the key driver has been the BOJ’s decision not to intervene so aggressively in bond markets. As a result, yields have risen, reducing the value of the bonds that banks hold. As those bonds are used as collateral for loans, it also reduces their ability to borrow in a hurry. That means less money for buying assets.

Where does all this leave us? The money supply growth numbers aren’t as terrifying as they first look. But it’s beyond denying that over history, swings in liquidity have driven some major market accidents, and there are other factors that could dry up the market. Or put very simply — we do need to talk about the plumbing, and that in itself is cause for vigilance.

Source from: Bloomberg