The dynamics of the global market vis-à-vis all those markets where a global liquidity that in 2019 reached 130 trillion dollars, well above the global GDP of 80 trillion dollars, is looking for a way out, tends to be the most decisive for the developments in the global economy. There are estimates that today this global liquidity, i.e. the total amount of cash and credit traded in the global financial markets, reaches 172 trillion dollars. This includes the liquidity of central banks, traditional commercial banks, but also so-called shadow banks that offer short-term debt and currency derivatives. The large increase in global liquidity in recent years has to do with the additional supportive credit lines that were formed during the pandemic period but also from the large increase in central bank assets through the last round of quantitative easing programs (and thus purchases of bonds and other securities from central banks). Except that this meant, among other things, that at the end of 2021 there was a total global debt of over $300 trillion, or about three times global GDP. Except that the debt must be repaid or recycled. Only these mean an annual refinancing need of even $60 trillion, which in turn means additional liquidity needs. But extra liquidity needs more debt as collateral, and extra debt needs more liquidity as refinancing, setting up a particularly defining cycle for the global economy as much of the capital markets transform into more debt refinancing mechanisms than financing modes. new investments. Except that this constantly creates conditions for liquidity crises, which in turn act destabilizingly for the global economy, whenever a conjunctural parameter changes and with it the policy of the central banks. And that is the question that arises amid rising inflation and pressure on central banks to raise interest rates and implement “quantitative tightening” policies.
“Dark Clouds” over Fixed Income markets
The problems that begin to exist in a changing context have already been seen in the case of Britain. The Truss government’s mini-budget which wanted to cut taxes and increase spending at the same time as the Bank of England launched an anti-inflationary policy led to a very large movement in the government bond market, which in turn threatened to blow up the financial position of the Pension Funds, which used them as a guarantee for short-term borrowing to buy additional bonds. In short, the same vicious circle between the expansion of liquidity and the inflation of debt.
However, clouds seem to be gathering in relation to the bonds of the US Department of Finance, Treasuries, a concern of 24 trillion dollars that essentially constitutes the basis of the global financial system. This market is now more volatile, the gap between bid and ask prices is widening and there is pressure due to the Fed’s departure from the policies of the previous period.
There have already been two episodes of liquidity crisis. One was in 2019 when the short-term interbank lending market froze, and the second with the very large crisis in the bond market on March 12, 2020, essentially as soon as it was made official that we were dealing with a pandemic: amid the insecurity created by the fear that we were heading for a sharp and major global economic recession and the nervous reactions of banks and other “players”, the fact that there was a greater reduction in liquidity in the bond market than in the futures market on bonds, creating a difference in their price, which in turn it meant that those who invested in the price difference between them were forced to sell bonds, driving down their prices, even though in the previous days there seemed to be a lot of demand. The Fed responded by intervening in the repos market to provide enough liquidity, but it was a strong sign that the economic phase shift after the end of quantitative easing threatens bond market stability.
But the Treasuries market is the largest, most substantial and deepest bond market on the planet. It is the foundation of the global financial system and is the benchmark from which the pricing of every other debt instrument begins.
The problems from the FED’s policy change
And the problem is that right now the Fed’s policy shift in the direction of more “quantitative tightening” is increasingly seen as creating a condition that increases the risk to market liquidity.
In theory, the policies of “quantitative easing”, i.e. the massive purchase of assets by central banks, imply an increase in bank deposits and lines of credit. This is why such policies are chosen as an anti-recession measure. But they carry the risk of inflationary trends. If these occur, then the reverse movement of “quantitative tightening”, that is, the cessation of large purchases by central banks and the attempt to reduce the amount of assets they hold, will force the banks to follow a more prudent and restrictive policy, which will also contributes to the reduction of inflation. However, there is a risk that if all this takes place at a time of great pressure, the reaction of market participants will be to look for short-term financing, at a time when this will not be enough for everyone, commonly there will be a liquidity crisis. And this means that reducing the assets of central banks is not a process that will always have beneficial results and involves real risks. It is no coincidence that a recent report by the Treasury Borrowing Advisory Committee (TBAC), which represents a wide range of institutions involved in the capital markets, recommends that there be a buyback of the less liquid bonds in order not to “freeze” the market. Of course there is the question of to what extent this is compatible with the overall trend towards ‘quantitative tightening’.
Political uncertainty is creating an uncharted transition period for the global economy
All of this has to do with the widespread sense that the global economy has entered fairly uncharted territory, characterized by recessionary dynamics, entrenched inflationary dynamics, productivity questions, supply chain problems, conflicting simultaneous pressures for fiscal “tightening” and for increased public spending and of course major geopolitical divisions and conflicts.
In this landscape and given the absence of large growth rates, coming from the real economy, the wider global financial system, which is in any case highly contradictory oriented towards a hyperinflation that is to a small extent transformed into investment, becomes a matter of course increasingly unstable.
But while usually instability starts at some “weak link” in the periphery, this time it is the bonds of major economies, in the way they are embedded in complex transactions, that threaten to act as a mechanism that could trigger a wider financial crisis. In that case, what we saw in Britain will be just the prologue.