The rat-a-tat-tat of interest rate cuts ricocheting around the markets is surely not enough. Widespread turmoil in markets underlines yet again that it is the volume of money that really matters, not the cost of it. Markets need extra support from central banks in crises because this is precisely when the flow of liquidity dries up.
Other central banks quickly need to match the US Federal Reserve and launch new rounds of quantitative easing, rather than make any further cuts to rates. We have probably already passed the so-called reversal rate, beyond which cuts actually harm the financial system and so destroy liquidity.
The 2007-08 global financial crisis — let’s call it GFC1 — was a supply shock to the liquidity mechanism, which caused a subsequent demand shock in the real economy. But this crisis, GFC2, is a supply shock to the real economy that has triggered a massive precautionary demand shock for more liquidity.
The September 2019 spike in repo rates should have delivered a warning similar to the 2007 failures of specialist mortgage lenders such as Northern Rock, ahead of GFC1. Now, world debt is about $130tn greater than in GFC1, according to our own calculations based on IMF figures. Within that, corporate debt is up by a whopping 155 per cent.
That $280tn or so of outstanding debt has an average five-year maturity, meaning that about $50tn-$60tn needs to be rolled over each year. That kind of funding demand is too great, because current financial balance sheet capacity is tight and lacking any margin of safety to absorb systemic shocks, such as coronavirus.
Mature financial systems are essentially refinancing mechanisms where balance sheet capacity is vital. Policymakers have failed to get to grips with this. Last time Chuck Prince of Citigroup took the prize for the most inappropriate quote of the crisis, when he said the bank was “still dancing”. This time it could be Christine Lagarde of the European Central Bank who said: “We are not here to close spreads.”
Worse than this, central banks have progressively pulled the rug from under themselves. In 1971, by ending the Bretton Woods system, they gave up control of their currencies. By the early 2000s, they had lost control of their banking and credit systems. In the past few years, although they would deny it vigorously, they have also lost control of their government bond markets.
Take, for example, the collapse in US 10-year Treasury yields, which are set by the markets and since GFC1 have dropped by a whopping 4.5 percentage points. And on Wednesday, excessive debts have become so pernicious and widespread that in the latest market rout even Treasuries have become questionable collateral.
It is true that US domestic banks now sit on huge excess reserves. It is also true that bond dealers hold Treasuries and many emerging market economies have self-insured against US dollar shortages with deep foreign-exchange reserves. But in crises, can these assets really be liquefied? So-called market liquidity and funding liquidity interact negatively during crises, because falling asset prices deplete collateral values and so destroy credit.
That puts strain on dealers and means that stock prices, which in normal times progressively climb the stairs, tumble down the escalator in crises because dealers cannot hold inventory.
The Fed’s balance sheet could easily top $6tn in coming weeks, up from about $4.3tn now. We should call this QE5, because strictly speaking, the rebound of about $400bn in the Fed’s post-September 2019 balance sheet was QE4.
Yet even this prospective QE5 total excludes possible future large-scale swap lines that address the coming demands from dollar-guzzling supply chains around the world, as their cash flows dry up.
In short, we still need more QE. Policymakers have not only caused ratios of debt to gross domestic product to accelerate sharply higher since GFC1 by cutting interest rates and cheapening credit, but have ignored the more dangerous drop in the coverage between the total pool of global liquidity available and world debts.
QE worked in 2008, inasmuch as it encouraged risk-taking activity and spurred bank lending. It will work again now, ideally alongside fiscal measures.
But policymakers’ knee-jerk reaction to cut rates ever lower only makes the situation worse by encouraging the demand for debt, while simultaneously destroying the supply of liquidity by stripping banks’ margins and reducing the incentive to lend, thanks to growing counterparty risks.
Too much debt is the shadow that loomed large over the previous crisis. And this one too.
The writer is managing director of CrossBorder Capital
