MAY 2024
US rate cuts may now be off the table this year, yet financial conditions should continue to ease. How so?
The answer lies in the fact the monetary and fiscal authorities continue to find new ways to provide policy stimulus, meaning borrowing costs are no longer the only game in town.
The chart below attempts to capture this dynamic and shows how the US “net liquidity” situation is changing. It’s a pretty blunt combination of the Federal Reserve balance sheet, the Treasury General Account (TGA) and the reverse repo facility. These are a variety of tools being used to control liquidity flows around the financial system.
When this indicator is rising it reflects money being pumped into the system, which tends to boost the economy and risk assets. The most obvious example being March 2020 when policymakers turned the liquidity taps wide open to counter the pandemic, sparking a big rebound in markets.
The gradual increase in this metric since late 2022 also helps to explain the bull market of the past 18 months. This has unfolded despite a sharp increase in interest rates.
Net liquidity has fallen slightly of late, reflecting the seasonal payment of US tax bills and lots of government debt issuance. In turn, this helps to explain why markets are consolidating after a strong six months.
What happens next? Combining the Biden administration’s wish to stimulate the economy and markets as we head towards the 5th November Presidential election with the Federal Reserve’s desire to keep the bond market under control, we expect this indicator to trend higher over the coming months. And this should support risk assets.
The Treasury General Account (TGA) is the US government’s current account at the Federal Reserve. It’s used to manage day-to-day Federal spending and is where the Treasury department deposits the funds it raises from tax receipts and new debt issuance.
In an era of politically-charged fiscal dominance it is playing an important role in market price action.
As a general rule, when the balance is rising it means liquidity is being sucked out of the financial system, which tends to coincide with a “risk off” trend in markets. Indeed, its recent spike to around U$1trn (a two-year high) is one of the reasons why equity markets have softened over the past few weeks.
That said, we can be reasonably confident that the TGA is more likely to fall than rise from current levels, particularly in an election year that will see the Democrats want to deploy funds in a way that boosts voter sentiment via economic growth initiatives and a rising stock market.
The risk, of course, is that further fiscal injections will lead to higher inflation rates, which are already settling well above the Federal Reserve’s 2% target. But, for now, the positive liquidity trend seems to be trumping any concerns over inflation and interest rates.
Something big seems to be brewing in currency markets with the Japanese Yen witnessing a 10%+ sell-off against the US dollar so far this year. It recently hit a three decade low around ¥160; a huge move for one of the world’s largest FX pairs.
So why is the Yen trading like an emerging market currency?
The recent increase in US bond yields has strengthened the US dollar, which has a direct (negative) impact on the Yen. If the US and Japanese economies were perfectly in sync, JGB yields would rise to a similar extent and that would largely neutralise the consequences for the currencies.
But that isn’t the case because the Bank of Japan (BoJ) is still pursuing a much looser monetary policy than the Federal Reserve, given the country’s colossal government debt/GDP ratio of over 250%, which easily eclipses America’s own fiscal problems.
Simply put, there is very little scope for Japanese bond yields to increase before they trigger a major debt refinancing crisis, which is why the 10yr JGB yield has risen only 0.3% this year (to 0.9%). Over the same period, the 10yr US Treasury yield has gone from 3.8% to 4.6%.
However, the defence of the Japanese bond market is coming at a cost via the weaker currency, which has accelerated in recent weeks.
In turn, this increases the likelihood of Japanese policymakers stepping in to support the Yen. Historically, they have done so by selling their dollar reserves and buying Yen with the proceeds. But that means selling some of their gargantuan US Treasury bond reserves, which totalled U$1.2trn at last count. And doing so forces US yields higher, catalysing the strong dollar/weak Yen dynamic again.
This is a complex and messy relationship known as an “FX doom loop”. One solution would be for the Federal Reserve to cut rates, but that seems unlikely with US growth and inflation perking up. This leaves other dollar liquidity provisions as a potential Yen saviour, including the reintroduction of FX swap lines or some form of Fed balance sheet manipulation.
We wouldn’t be surprised to see a co-ordinated Central Bank intervention over the coming weeks, aimed at keeping the dollar rally in check. In fact, based on the recent Yen bounce some “stealth” intervention may already be underway.
Whilst US policymakers tend to have the biggest influence on the global liquidity cycle (for good or bad) it’s important not to forget the pivotal role the Chinese authorities also play in setting the tone for financial flows.
Indeed, until the middle of last year, Chinese policy was restrictive as the government strived to clamp down on prior excesses (particularly in the property sector). This amplified the headwinds for the global economy and markets borne of the spike in US interest rates.
Fast forward to today and the authorities have reverted to a pro-stimulus approach as they seek to combat ongoing real estate weakness and the resulting deflationary threat (headline CPI was just +0.1%y/y in March and hasn’t been above 1%y/y in over a year).
The chart below is simple way of showing how more liquidity is starting to flow into the Chinese financial system.
It tracks the total amount of 1-year loans being provided by the PBoC (the Central Bank) to financial institutions in any given month. A higher figure denotes more money flowing to commercial banks and other credit providers which, in turn, increases the amount of funding available in the global economy and markets.
It can be a very volatile number, but the major spikes in late 2023 and earlier this year, reinforce the point the Chinese authorities have become more assertive of late. This means China is now making a positive contribution to the global liquidity cycle upturn that began in late 2022.
The content of this document is for information purposes only. The authors believe that, at the time of publication the views expressed and opinions given are correct. No guarantee in performance of investment can be given to readers intending to take action based upon the content of this document. It is reminded that this document is a matter of opinion and any person wanting to invest in this market should first consult with the professional who can advise on their financial affairs. Any such investment will see your capital at risk, and you may get back less than you invest. Any companies cited in this report are used to support the view of the authors and should not be construed as recommendations to purchase or sell the underlying securities. Neither the publisher nor any of its subsidiaries or connected parties accepts responsibility of any direct or indirect or consequential loss suffered by a reader or any related person as a result of any action taken, or not taken in reliance upon the content of this document.
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