In part one, we discussed how the global economy and capital markets had become interconnected, dependent upon and inflated by liquidity and vulnerable to exogenous shocks, such as higher oil prices or supply shock inflation.
Even though Quantitative Tightening (QT), namely reversing the huge run up in asset purchases by governments by selling them (or rather simply not buying when existing fixed term investments mature), has barely begun, the effects of diminishing liquidity have been apparent for some time.
Liquidity tends to have immediate impacts. Many of these impulses need continuing inflows to be sustainable. The run-up in the price of stocks and funds such as the ARK Innovation ETF (ARKK) owed a great deal to short term liquidity and very little to long term financial fundamentals.
On the 18th of March 2020, ARKK fell to a price of $33.00 per share. The injection of liquidity into the system by Fed and Treasury was just beginning at that point.* Within days, liquidity had fed into markets and bubbliest assets benefitted the most:
By the end of May, ARKK’s share price had almost doubled as the Fed balance sheet had swollen by 65%. Zoom out to show the first half of 2020 and this effect is even more apparent:
In the weeks and months that followed the ARKK share price continued to boom to $159.70 per share by February last year. However, even though the Fed continued to purchase assets, it did do so at a much less parabolic frenzy:
We pointed out at the time** that if liquidity-fuelled bubbles aren’t constant fed with ever more liquidity, otherwise gravity bites….very hard.
When the ARKK share price traded over $150 we warned that without the fillip of continued liquidity, it would be in danger of returning to its original price. This is exactly what happened – other liquidity hypersensitive assets have followed similar patterns – as we can see when we compare ARK and Bitcoin:
So the ARKK foundered or maybe even ‘sankk’…But what about liquidity impacts across broader markets or on the economy?
The US banking sector has benefitted hugely from the Fed’s generous asset purchase programmes, probably none more so than JP Morgan. In Europe, however, the effect of the ECB’s range of acronymic asset purchases on the banking sector has been anaemic in comparison (as in Switzerland has the SNB’s). This is evident in the relative share price performance (JPM pink line, Deutsche black line, Credit Suisse turquoise):
Share price isn’t everything but Deutsche and Credit Suisse, which largely tracked JPM on the way into the GFC, remain over 90% below their pre GFC prices (whereas JPM is 140% higher). This is a strong indicator that European banks haven’t been able to rehabilitate. It’s also indicative of the constraints faced by EuroZone policymakers, faced with the impossible task of maintaining stability within the single currency’s operating remits.
EuroZone banks generally never recovered from the GFC. They remain much more vulnerable to the impact of the next crisis than their American cousins.
The next crisis may be imminent, as Europe already faces a grim combination of headwinds, from threats of a much deeper recession, which policymakers can do little to mitigate, the energy crisis and rising geopolitical tensions, all set against a backdrop in which global liquidity is drying up.
Major economies, such as Italy, look susceptible to economic crises which could reverberate through the Italian banking system into the broader EuroZone banking system. Fault lines would very likely intersect with systemically vulnerable institutions, which is why rumours have swirled around Deutsche, Credit Suisse and other major European banks in recent weeks. While we’re not aware of any specific immediate threats to either, we’d very much see the emergence of existential threats to the most vulnerable EuroZone banks at some stage as almost inevitable.
The Fed has also been the subject of commentary, partly prompted by losses on its portfolio remittances.*** In simple terms, the Fed now finds itself paying out more interest, mainly to banks, than it collects, mainly from the government or government agencies. As the Fed is essentially an extension of government (technically a hybrid public/private sector entity ‘independent within the government’), it is obliged to remit surplus interest that it collects from the government back to the US Treasury. As the Fed balance sheet expanded, these remittances had increased to almost $200 billion in the last 2 years and around $1 trillion since the GFC.
The Fed predominantly holds fixed-rate instruments but pays interest to banks and financial institutions on the reserves deposited at the Fed at current, market rates. Therefore, the Fed’s interest hikes have meant that the Fed has become a victim of its own policies. It is now paying banks more interest than it earns.
If the Fed were a pension fund, it might fire its managers for mismatching liabilities and income. But it isn’t. And it won’t.
In many ways, this is convenient for the Fed in that the remittances are a source of funding of government spending and reducing government spending will slow the economy further, which is the Fed’s misguided strategy to tackle inflation. Also, this will bolster banking profits. In turn, this helps, to a marginal extent, to further shore up US bank balance sheets.
Other reports show that the Fed, in the first half of this year, would have taken a hit of over $700 billion on the value of its asset holdings.****
But the Fed doesn’t price its asset holdings to market (for the good reason that it rarely sells them – even the current QT programme is simply a run-off of maturing assets rather than a major asset dump into the market).
Despite some hysterical reactions, the Fed isn’t going broke. Ultimately, unlike the ECB, the Fed is underwritten by the sovereign credit of USA and while ever America issues its own currency, USG cannot go broke.
These are not real losses. The Fed doesn’t feel real pain.
The continued tragicomedy melodrama that is the UK Government is the toxic gift that keeps on giving and giving so we plan to write about that next week, explaining that the combination of Prime Minister Liz Truss, Chancellor of The Exchequer Kwasi Kwarteng and Bank of England Governor Andrew Bailey might just be the UK’s main systemic risk right now.
But the fundamental factor that has shipwrecked ARKK, and is now causing nerves to jangle in global financial institutions is tighter liquidity, leading to increased funding costs, falling asset prices, higher default rates and economic slowdown, creating a spiral which leads to even tighter liquidity in a vicious spiral down.
This is a potentially toxic brew that can quickly turn fatal when it encounters existing vulnerabilities – we’ve already seen this at the most sensitive parts of the system – it’s just a question of how much damage policymakers are willing to inflict on the liquidity leviathan of their own making and who will bear the brunt of that.
*The first significant increase in asset purchases by the Federal Reserve was during week ending March 18th when the Fed balance sheet which had generally been stable, moving by less than 1%, suddenly ballooned by over 8% https://fred.stlouisfed.org/series/WALCL
MBMG Investment Advisory is licensed by the Securities and Exchange Commission of Thailand as an Investment Advisor under licence number Dor 06-0055-21.
For more information and to speak with our advisor, please contact us at info@mbmg-investment.com or call on +66 2 665 2534.
About the Author: Paul Gambles is licensed by the SEC as both a Securities Fundamental Investment Analyst and an Investment planner.
Disclaimers:
1. While every effort has been made to ensure that the information contained herein is correct, MBMG Investment Advisory cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of MBMG Investment Advisory. Views and opinions expressed herein may change with market conditions and should not be used in isolation. 2. Please ensure you understand the nature of the products, return conditions and risks before making any investment decision. 3. An investment is not a deposit, it carries investment risk. Investors are encouraged to make an investment only when investing in such an asset corresponds with their own objectives and only after they have acknowledge all risks and have been informed that the return may be more or less than the initial sum.
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In Lehman’s Terms (Part Two – Haunted by Ghosts of Crises Past)
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In part one, we discussed how the global economy and capital markets had become interconnected, dependent upon and inflated by liquidity and vulnerable to exogenous shocks, such as higher oil prices or supply shock inflation.
Even though Quantitative Tightening (QT), namely reversing the huge run up in asset purchases by governments by selling them (or rather simply not buying when existing fixed term investments mature), has barely begun, the effects of diminishing liquidity have been apparent for some time.
Liquidity tends to have immediate impacts. Many of these impulses need continuing inflows to be sustainable. The run-up in the price of stocks and funds such as the ARK Innovation ETF (ARKK) owed a great deal to short term liquidity and very little to long term financial fundamentals.
On the 18th of March 2020, ARKK fell to a price of $33.00 per share. The injection of liquidity into the system by Fed and Treasury was just beginning at that point.* Within days, liquidity had fed into markets and bubbliest assets benefitted the most:
By the end of May, ARKK’s share price had almost doubled as the Fed balance sheet had swollen by 65%. Zoom out to show the first half of 2020 and this effect is even more apparent:
In the weeks and months that followed the ARKK share price continued to boom to $159.70 per share by February last year. However, even though the Fed continued to purchase assets, it did do so at a much less parabolic frenzy:
We pointed out at the time** that if liquidity-fuelled bubbles aren’t constant fed with ever more liquidity, otherwise gravity bites….very hard.
When the ARKK share price traded over $150 we warned that without the fillip of continued liquidity, it would be in danger of returning to its original price. This is exactly what happened – other liquidity hypersensitive assets have followed similar patterns – as we can see when we compare ARK and Bitcoin:
So the ARKK foundered or maybe even ‘sankk’…But what about liquidity impacts across broader markets or on the economy?
The US banking sector has benefitted hugely from the Fed’s generous asset purchase programmes, probably none more so than JP Morgan. In Europe, however, the effect of the ECB’s range of acronymic asset purchases on the banking sector has been anaemic in comparison (as in Switzerland has the SNB’s). This is evident in the relative share price performance (JPM pink line, Deutsche black line, Credit Suisse turquoise):
Share price isn’t everything but Deutsche and Credit Suisse, which largely tracked JPM on the way into the GFC, remain over 90% below their pre GFC prices (whereas JPM is 140% higher). This is a strong indicator that European banks haven’t been able to rehabilitate. It’s also indicative of the constraints faced by EuroZone policymakers, faced with the impossible task of maintaining stability within the single currency’s operating remits.
EuroZone banks generally never recovered from the GFC. They remain much more vulnerable to the impact of the next crisis than their American cousins.
The next crisis may be imminent, as Europe already faces a grim combination of headwinds, from threats of a much deeper recession, which policymakers can do little to mitigate, the energy crisis and rising geopolitical tensions, all set against a backdrop in which global liquidity is drying up.
Major economies, such as Italy, look susceptible to economic crises which could reverberate through the Italian banking system into the broader EuroZone banking system. Fault lines would very likely intersect with systemically vulnerable institutions, which is why rumours have swirled around Deutsche, Credit Suisse and other major European banks in recent weeks. While we’re not aware of any specific immediate threats to either, we’d very much see the emergence of existential threats to the most vulnerable EuroZone banks at some stage as almost inevitable.
The Fed has also been the subject of commentary, partly prompted by losses on its portfolio remittances.*** In simple terms, the Fed now finds itself paying out more interest, mainly to banks, than it collects, mainly from the government or government agencies. As the Fed is essentially an extension of government (technically a hybrid public/private sector entity ‘independent within the government’), it is obliged to remit surplus interest that it collects from the government back to the US Treasury. As the Fed balance sheet expanded, these remittances had increased to almost $200 billion in the last 2 years and around $1 trillion since the GFC.
The Fed predominantly holds fixed-rate instruments but pays interest to banks and financial institutions on the reserves deposited at the Fed at current, market rates. Therefore, the Fed’s interest hikes have meant that the Fed has become a victim of its own policies. It is now paying banks more interest than it earns.
If the Fed were a pension fund, it might fire its managers for mismatching liabilities and income. But it isn’t. And it won’t.
In many ways, this is convenient for the Fed in that the remittances are a source of funding of government spending and reducing government spending will slow the economy further, which is the Fed’s misguided strategy to tackle inflation. Also, this will bolster banking profits. In turn, this helps, to a marginal extent, to further shore up US bank balance sheets.
Other reports show that the Fed, in the first half of this year, would have taken a hit of over $700 billion on the value of its asset holdings.****
But the Fed doesn’t price its asset holdings to market (for the good reason that it rarely sells them – even the current QT programme is simply a run-off of maturing assets rather than a major asset dump into the market).
Despite some hysterical reactions, the Fed isn’t going broke. Ultimately, unlike the ECB, the Fed is underwritten by the sovereign credit of USA and while ever America issues its own currency, USG cannot go broke.
These are not real losses. The Fed doesn’t feel real pain.
The continued tragicomedy melodrama that is the UK Government is the toxic gift that keeps on giving and giving so we plan to write about that next week, explaining that the combination of Prime Minister Liz Truss, Chancellor of The Exchequer Kwasi Kwarteng and Bank of England Governor Andrew Bailey might just be the UK’s main systemic risk right now.
But the fundamental factor that has shipwrecked ARKK, and is now causing nerves to jangle in global financial institutions is tighter liquidity, leading to increased funding costs, falling asset prices, higher default rates and economic slowdown, creating a spiral which leads to even tighter liquidity in a vicious spiral down.
This is a potentially toxic brew that can quickly turn fatal when it encounters existing vulnerabilities – we’ve already seen this at the most sensitive parts of the system – it’s just a question of how much damage policymakers are willing to inflict on the liquidity leviathan of their own making and who will bear the brunt of that.
*The first significant increase in asset purchases by the Federal Reserve was during week ending March 18th when the Fed balance sheet which had generally been stable, moving by less than 1%, suddenly ballooned by over 8% https://fred.stlouisfed.org/series/WALCL
** https://t.co/Axc7NxcNzD https://t.co/2upnIl02MQ https://t.co/Z4utzt5PeV https://t.co/euSB4fUSZn & https://t.co/tLBbSgmrRo
*** https://www.bloomberg.com/news/articles/2022-10-10/it-s-official-the-fed-s-in-the-red
**** https://www.ft.com/content/ddc5d867-59fe-4c9b-a588-4066304318b6
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MBMG Investment Advisory is licensed by the Securities and Exchange Commission of Thailand as an Investment Advisor under licence number Dor 06-0055-21.
For more information and to speak with our advisor, please contact us at info@mbmg-investment.com or call on +66 2 665 2534.
About the Author:
Paul Gambles is licensed by the SEC as both a Securities Fundamental Investment Analyst and an Investment planner.
Disclaimers:
1. While every effort has been made to ensure that the information contained herein is correct, MBMG Investment Advisory cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of MBMG Investment Advisory. Views and opinions expressed herein may change with market conditions and should not be used in isolation.
2. Please ensure you understand the nature of the products, return conditions and risks before making any investment decision.
3. An investment is not a deposit, it carries investment risk. Investors are encouraged to make an investment only when investing in such an asset corresponds with their own objectives and only after they have acknowledge all risks and have been informed that the return may be more or less than the initial sum.