Less liquidity, less fun | Financial Time


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Hello. I’ve received plenty of responses to Monday’s dollar coin, two of which I write about below, but it’s a topic I’ll likely come back to as the week goes on. People seem to like to think about it.

Shameless FT Plug: Raw materials are a big deal again. So check out the FT’s Global Commodities Summit, which takes place Tuesday and Wednesday. Register for the event here.

Email me: robert.armstrong@ft.com

The flow of cash flows a little slower

This line has been going pretty much straight lately:

What you are looking at is the volume of the reverse repo. The Fed sold, oh, half a trillion dollars in Treasuries overnight for cash, with a deal to buy them in the morning at a slightly higher price. In other words, investors gave the Fed very short-term guaranteed loans. This is interesting because at the same time, in a separate transaction, the Fed is still buying $ 80 billion in long-term Treasuries per month.

Here is the definition of reverse repo by the New York Fed:

In a reverse repurchase transaction [the Fed] sells securities to a counterparty subject to an agreement to repurchase the securities at a later date at a higher repurchase price. Reverse repurchase transactions temporarily reduce the amount of reserve balances in the banking system.

It is a way for the Fed (to use the expression preferred by all) “to mop up excess liquidity”. There is so much liquidity in the financial system that short-term rates, including repo rates, Treasuries, and the Fed’s policy rate, all threaten to fall below zero. The Fed has long said it doesn’t like negative interest rates, so it pulled out the mop.

The reason this is important for investors is that the amount of liquidity in the financial system and asset prices appear to be linked. I spoke about this on Monday with Michael Howell, whose research at CrossBorder Capital focuses on global liquidity.

Howell noted that there is debate among liquidity watchers as to whether the Fed’s half-trillion reverse repurchase transaction is simply “technical” (a response to a particular problem in the Fed. functioning) or is in fact a backdoor way to start gradually reducing QE. He doesn’t have a strong opinion anyway. The point for him is that, in part because of the Fed’s reverse repo, global liquidity growth is slowing. This is very likely to affect asset prices. Indeed, he thinks that is already the case. Howell sees the imprint of the change in liquidity in the sideways stock markets of the past few months and in the flattening of the yield curve.

There are different ways of measuring the slowdown in global liquidity, but the simplest is to observe, as Howell does, that the balance sheets of the world’s central banks increased by $ 483 billion in May, or less than half of April’s expansion and well below May 2020 levels. Howell also provides the graph below, showing the annual change in base money (in yellow) slowing from 35 percent to 20 percent in recent weeks ( the red line is an index of the total stock of newly granted savings and credit in 80 countries):

The bottom line is that when the amount of cash decreases, investors’ portfolio preferences change – they are happy to hold less risk. Hence this approximate long-term relationship between changes in global liquidity (again, savings plus newly issued credit instruments) and changes in total wealth (stocks, bonds, gold, real estate):

Howell’s way of thinking is new to me, so I’m not sure I got it right. But it may be useful to contrast them with Robert Shiller’s classic model of Irrational exuberance. Shiller’s point of view is that the valuation of assets, relative to their cash flows, fluctuates around a fairly stable average, with deviations from the average being due to changes in the level of investor optimism. . Howell says the variation around the mean is largely the product of cash flow, which changes investors’ portfolio preferences. Of course, the two models can be complementary.

Another look at the dollar

Monday I wrote this:

The United States buys far more products from the rest of the world than the world buys from the United States. This difference must be financed; from the point of view of mathematical identity, there must be an influx corresponding to this outflow. There could be inflows in the form of, for example, foreign direct investments in US real assets or, as is more often the case, investments in US securities, most often our sovereign bonds.

I was trying to characterize a popular view of why the dollar must fall – the “twin deficits” hypothesis – rather than giving my own thoughtful opinion. But I still should have been more careful. This paragraph assumes that trade imbalance leads to capital account imbalance. But all we really know is that the trade account and the capital account have to be zero, from an accounting point of view. We don’t know which way the causality is going. It could be that the capital account surplus causes the trade deficit.

The person who challenged me on this subject is the financial economist Michael Pettis, in a series tweets:

Viewing the trade imbalance as the cause is easy and intuitive, as I demonstrated on Monday. The story is, Americans are lazy big consumers who don’t make stuff anymore, but buy a lot of stuff that skinny, hardworking foreigners make. This leads to a trade imbalance which must be compensated by inflows of capital into the United States – purchases of bonds by the Chinese, etc.

Pettis’ point (expressed with maximum simplicity if not precision) is that there is a lot of excess savings in the world, especially in China, Germany and Japan, resulting mainly from bad economic policy. Much of this excess savings is funneled to the United States because there are no other capital markets open or deep enough to take them away. America is becoming the “shock absorber” of global imbalances in savings and investment (or if you prefer, insufficient demand). The capital account, the massive influx of excess global savings, determines the trade balance, not the other way around.

This story is hardly intuitive. How are American consumers forced to buy things, or the United States to borrow, just because capital from the rest of the world wants to come to America? Well, for example, foreign capital could end up in the hands of American consumers and turn into consumer spending, through financial institutions that provide these consumers with very cheap loans to finance consumption. As economist Amir Sufi has pointed out, think of the senseless American rebranding of second mortgages as “home equity loans”. It is a symptom of the fact that global capital is making its way into the United States and encouraging deficit spending in the United States using good old marketing.

For our purposes, the point is, if you think America’s deficits are caused by international savings flows, rather than domestic debauchery, you’re probably less likely to think the dollar is doomed to depreciate.

Yet another look at the dollar

On Monday, I used a graph from Jason Trennert of Strategas, showing that price-to-earnings ratios have tended to fluctuate with the dollar since 1990 – which makes sense, conceived in terms of global capital flows. Ian Harnett from Absolute Strategy Research emailed me to let me know that if you go back further, the correlation doesn’t hold up at all:

There was a regime change in this relationship in the late 1980s. Do we have another now?

A good read

There was an interesting article in the New York Times this weekend about how executive awards have skyrocketed in recent years, especially in the tech arena. Managers are now paid like entrepreneurs. I don’t know how much of a problem this is. It seems to me a serious but probably not a catastrophic waste of shareholders’ money. But if you get paid so much to run a business for a few years that your great-grandchildren never need to work, will that make you a better manager or turn you into a nutcase? I think the latter would be a real possibility.

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