E Shrinking Global Liquidity Raises A Red Flag In The Equity Markets

It is a well-established that recessions can be traced back to developments in the capital markets. We recall that the previous two American recessions were caused by excesses in capital spending leading to a misallocation of financial resources which culminated in a very sharp downturn in economic activity. The excess capital going to the dot-com and telecom industries resulted in their eventual collapse and the 2000-01 recession. The misallocation of financial capital in the U.S. housing and mortgage industries had major repercussions worldwide in 2008-9. Despite all the heroic efforts by central banks to re-invigorate economic activity worldwide since 2009, there are no signs of excess capital spending in any particular sector that would be a warning of an impending recession. Yet, there is considerable gloom among investors that a recession is on the horizon and this gloom is seeping into the equity markets.

One of the major concerns is that global liquidity is steadily contracting as the Fed shrinks it’s a balance sheet. Recall that successive bond-buying programs resulted in the Fed’s balance sheet growing from $800 in 2008 to over $4 trillion by 2016. In turn, the monetary base expanded and increasing amounts of liquidity were pumped into the banking system. Now, the Fed is putting this program into reverse. The Fed is leading the way in withdrawing liquidity from the world’s banking systems. Every time it allows a bond to be held to maturity without re-investing, it is removing reserves from the banking system. The withdrawal is currently running at about $50 billion a month. Many analysts liken this “quantitative tightening” to the equivalent of several rate hikes. Recent statements by the Federal Reserve Chairman Powell re-affirms the Fed’s commitment to shrink its balance sheet, thus ensuring further liquidity tightening.

Last month the ECB confirmed that they will stop expanding quantitative easing from the end of December. Bond purchases will fall from 15 billion euros a month to zero. The ECB's asset purchasing program resulted in the bank buying more than 2.6 trillion euros ($2.9 trillion) since March 2015 in a bid to rescue the eurozone economy from deflationary forces.

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Gary Anderson 4 months ago Contributor's comment

I am listening to Mike Mayonaise Mayo telling us on CNBC that consumer credit is just fine. How does that reconcile with your research, Prof?

Norman Mogil 4 months ago Author's comment

My point is that on the corporate side, which means "investment" in the GDP component, money is getting tighter and more expensive. That segment has been increasing debt levels without an commensurate increase in output ( the marginal productivity of capital investment has been falling). We know that the tax cuts did not go into debt reduction or into growing the capital stock--- it was rewarding shareholders. So, the existing debt needs to rolled over and new debt is needed for new investment. Now, the central banks are making matters worse. and that is reflective in the spreads and the deteriorating quality of the lender. Today, Gundlach argued that about half of BBB bonds, the lowest segment of investment grade should be downgraded to junk which tells you how bad is the quality of debt. That would result in more liquidation by funds who cannot hold junk debt. Remember US corporate debt stands at $6 trillion so there is a lot of debt to negotiate out of.

Gary Anderson 4 months ago Contributor's comment

Prof, there is a debate as to whether the Fed is tightening or not. GDP seems to be holding up. My question is whether you think the bad bbb and lower debt is massive enough to reflect that the Fed is indeed tightening, or is it not significant enough to prove tightening?

Norman Mogil 4 months ago Author's comment

I am not sure how else one can interpret that sucking out $50b a month as anything other than tightening. Bernanke warned against shrinking the balance sheet until interest rates were ' normal' --presumably much higher than today's because the normal rates would signal that growth was strong and tightening would not slow growth. However, the Fed started that process too early and the equity markets are not suffering from this withdrawal and from trade policies gone amok and China sliding. So, maybe the bad BBB debt is caused by the trade fight or by general slowing. Regardless, withdrawing cash from the system is not helping.