Eureka: the Archimedes principle

According to the Archimedes principle, any object submerged in a fluid is buoyed by a force equal to the weight of the fluid displaced. It’s the reason that solid metal objects (e.g. anchors) sink but hollow metal objects (e.g. ships) do not.

Central bank reserves are the fluid that helps to lubricate global financial markets. As part of the monetary base, they are the apex of the liquidity pyramid: no other asset is free from mark-to-market or default risk. No other asset is freely convertible into currency with zero transaction costs. However, over the course of 2018, US dollar reserves are set to shrink by around $400 billion as the Federal Reserve’s quantitative tightening (QT) programme ramps up.

As US dollar liquidity is withdrawn, will it lead to a force equal to the value of the assets displaced? In other words, will QT sink markets faster than the Titanic or will they continue to be buoyed by low interest rates, low default rates and decent earnings growth?

When faced with a policy experiment such as QT, we can look to economic theory for clues as to its likely impact. But, we can also look to the past and to present-day analogies.

Learning from the theory

From first principles, QT involves the substitution of one liquid asset (reserves) for another marginally less liquid asset (sovereign bonds) in the funding mix of the public sector. Liquidity is impaired by the operation, but we shouldn’t expect a sea-change. Sovereign bonds count alongside banknotes and central bank reserves as high-quality liquid assets (HQLAs) for the banking sector. They can be sold or lent to meet liabilities with minimal transaction costs or market impact.

When worrying about QT, we therefore shouldn’t obsessively focus on the reduction in reserves per se. Instead, we should focus on the standard 'crowding out' effect beloved in economics textbooks: higher bond supply puts upward pressure on real interest rates; higher rates incentivise investors to reallocate away from risky assets and into government securities.

Urjit Patel, the Governor of the Reserve Bank of India, put it fairly clearly in a recent article. He spoke of a “double whammy” for global markets as QT collides with higher bond issuance from the US treasury to finance the Trump administration’s fiscal largesse.

The numbers involved are undoubtedly large. The private sector will need to absorb around $1 trillion of additional USD government bond supply this year and around $1.4 trillion next year. That compares to $500-700 billion in each of the last three years.

This should put upward pressure on interest rates as the market is required to digest increased duration risk. If we assume a fixed supply of savings, then greater supply of government bonds must also imply less demand for other (i.e. riskier) assets.

Learning from the past and the present

 The most comprehensive overview of comparable historical episodes is co-authored by Professor Niall Ferguson. It finds that:

“Balance sheet reduction episodes have gone hand-in-hand with lower growth rates, somewhat lower inflation rates and substantial slowdowns in finance sector lending activity”

The authors warn that QT episodes tend to be exceptionally protracted and go hand-in-hand with weakness in asset prices and choppy economic conditions.

The analogy isn’t perfect as most of the historical observations are concentrated in the post-war deleveraging of the 1950s. However, as discussed in a recent post, we also have an important modern day episode to consider in Hong Kong.

QT involves the shrinking of the pool of reserves available to settle interbank liabilities. In the US, that process has started slowly: since the end of 2014, the “Total Factors Supply Reserve Funds” have shrunk by around 4% in a slow and deliberate fashion. US markets are the metaphorical frog placed in a pan of slowly warming water: liquidity conditions are tightening, but the rate of change is almost imperceptibly slow.

However, in Hong Kong, the equivalent Aggregate Balance has dropped by 40% in the last few months as the Hong Kong Monetary Authority has fought to defend its pegged exchange rate.

QT has therefore been rapid and active. The Cantonese frog has been suddenly plunged into a boiling pan: interest rates have risen by around 0.5% and equity markets have underperformed by nearly 10%. There hasn’t yet been monetary mayhem in the Hong Kong policy petri dish, but the omens for global assets are not exactly great.

In conclusion, Archimedes is reported to have had his 'Eureka' moment while lolling in the bath before running down the street in a state of undress. For the financial market equivalent of the Archimedes principle, we need to turn from the Sage of Syracuse to the Sage of Omaha.

As Emiel recently reminded us, when thinking about the impact of liquidity withdrawal, we could do a lot worse than to simply remember Warren Buffett’s infamous aphorism:

“It’s only when the tide goes out that you discover who's been swimming naked”