The Global Collateral Trap
The Expert View
Featuring Michael Howell
Published on: May 8th, 2019 • Duration: 29 minutesCould a global collateral crunch cause “hair-trigger” markets to plunge into a 2008-style sell-off? Michael Howell, founder and managing director of CrossBorder Capital, breaks down the causes, and likely effects, of a liquidity crisis in global financial markets. Filmed on May 2, 2019 in London.
MICHAEL HOWELL: I don't think policymakers can afford to let asset markets collapse in the way that they've collapsed before. The simple reason is that this is the main source of demand.
This is a feature of markets, we're going to see more and more episodes like December of 2018. Very sudden shots, people panic, you get blunt selloff symbols straight, and then calming words from central bankers, maybe they'll rebound again.
If you look at the reaction of financial markets to economic events, they're on a hair trigger. And only a little bit of bad economic news and markets plunge. A little bit of good economic news, they power up again. And I've never seen sensitivity of that degree.
I'm Mike Howell, I'm CEO of CrossBorder Capital, based here in London. My background has been in research. I've been in financial markets probably 30 years, originally at Salomon Brothers, and then I had a research at Bearings.
Why does liquidity matter more than interest rates?
If you look at the financial system, effectively, the financial system relates to an economy that is now not raising new capital. It's effectively refinancing its existing capital. And that goes back to the change in the world economy that we saw around the fall of the Berlin Wall. Emerging markets came in, it made it very unprofitable for Western industry to set up new plant. Consequently, they didn't. They just went into for cost restructuring. And effectively, what they're doing is just raising their cash flows.
And what you're seeing in Western financial markets now is effectively a big roll. They're taking on debt, they're refinancing. If you're refinancing, it's not the interest rate that really matters- it's the capacity. It's the ability to roll your positions over. And balance sheet is all important. That is what our measures of liquidity are all about. They're measuring balance sheet size.
On the debt question, it's what you really need if you've got debt is to be able to roll that position over. You either pay it back or you refinance it. And the refinancing is really a critical question. Now, we're not saying that interest rates are completely unimportant, they're not. But it's the ability to do that roll that's important. And what you need is balance sheet capacity.
Now, there are a whole lot of changes in the financial system, which make it complicated, which I'll come on to. But basically, if you've got a balance sheet, which is the wrong size, or inappropriately structured, you basically get mismatches. And mismatches are really what drive financial markets. That's where you get risk premium reemerging.
And fundamentally, there are three basic- if you like, fault lines that expose risk premium that we tend to look at. One is effectively a maturity mismatch. So, in other words the financial system has got this too short or too long-dated debt. The second question is credit risk. The whole question about the quality of what you're holding. Is it poor quality? Is it good quality debt? And the third one is foreign exchange risk.
Now, where they come through is in really three particular spreads. One is the maturity spread, the term spread, if you like, the slope of the yield curve, call it that. The second one is the credit spread. In other words, the quality spread, what's the spread between junk debt, and Treasury. And the third one is the FX swap spread. These are the factors that really matter.
And if you see these spreads beginning to blow out, then you've got mismatch problems. And the financial system is creaking. Because balance sheets are inadequate in terms of the size, and there are mismatches being exposed. And that's what December was all about, and effectively, if you go back a decade, that's what 2007-2008 roll was all about.
What are the sources of liquidity?
Let's go back to the structure of the global financial system. What's happened in the last 20 years, this has become far less bank-based, far less nationally-based, it's now much more global. It's based around wholesale funding markets where collateral is really the critical question. In other words, to extend credit, you need collateral. And the whole financial system rests on this base of collateral.
Now, what we got to think about is how structure has changed. And the structure has principally changed in two ways. One is central banks have effectively been forced to become a lot more active. They used to sit much more on the sidelines 20, 30 years ago, they now have to be at the forefront of these flows within the money markets. The second issue is the growth of corporate and institutional cash pools. Now, this is a complicated, slightly wonkish concept. But let me try and go through it.
What you've had in the last 20 years is a growth of corporations who got these cash piles. They're not investing in new plans and equipment, what they're doing is they're basically holding it in Treasury. You've got big technology companies in the US who are throwing off cash. They don't need Capex. What do they do with it? They're holding it in their treasury departments. So, that's one source. And that's probably in America right now, a pool of about two to $3 trillion. Wasn't there before.
Second thing is the growth of things like sovereign wealth funds. They've suddenly come on the scene. What's their balance sheet? $5 trillion, at least that sort of magnitude. You've got things on the Norwegian sovereign wealth fund a trillion, you've got CIC in China about another trillion, etc. These are big, big numbers. Then you've got the growth of foreign exchange reserves. This has really been a phenomenon that's come in principally since the Asian crisis right back in '97, '98. You saw a big growth in foreign exchange reserve holdings like jumped globally by about $10 trillion. And they jumped in emerging markets by about seven.
Now that needs to be managed, they need safe assets to put these foreign exchange reserves in. Now on top of that, you've got wealth managers who have seen large inflows of money because of demographic change, they need to manage that cash. And then on top of that, you've got derivative futures exchanges, which need cash collateral. So, there's tremendous structural demands for cash within the system. And this is really coming through the wholesale money markets.
Now, the question is they need safe assets, they need safe liquid assets. How do you create them? Well, the opportunities in the system are basically treasury bills or bank deposit accounts. Okay? That's where we've traditionally been. Austerity policies by governments mean there's not very much government debt around. The banks have been essentially just outweighed or outgrown by these corporate and institutional cash pools.
In other words, if you're a big corporation and you're sitting on $20 million, are you prepared to put it into a bank? You'd be crazy to do that, because the banks are vulnerable. They've only got deposit guarantees in America of $250,000, way smaller than your 20 million. In Europe, it's about 100,000 euros. So, effectively, what you've got to do is to find a secure asset.
So, what happens is the money markets effectively repo debt. They can repo government debt. They can repo private debt. But what they're effectively doing is creating a short-term instrument, which has got this cash collateral. And that's what these big institutional cash pools are really feeding right now.
Now, the problem basically comes is if you run out of things to collateralized, and that's the problem. So, if you've got central banks, they're doing QE, or they're sucking up the Treasury debt. And you've got treasuries themselves, so we're just not issuing debt. Where does the collateral come from? It basically has to come from the private sector.
So, what you'll see in the US right now is tremendous issuance in the BBB market, just about investment grade. That's been skyrocketing in issuance terms. But that's because there's big, big demand for quality private sector debt to collateralized for this repo market. And what you'll see in the US, and bear in mind that let's take a global perspective here. It's really only Wall Street that's having a bull market. And the question that your viewers need to ask is, why is this bull market only really in the US principally?
The reason being is a lot of this cash that corporations in America are getting, because of the ability to issue corporate debt is being funneled back into Wall Street through share buybacks. So, what you've got is essentially a pyramid which looks quite shaky. And the problem comes is if you get a breakdown in these wholesale markets.
Now, we've seen that once before, we saw it in 2007-2008. It wasn't corporate debt the problem then, it was mortgage backed securities, they were flaky. If there's a problem in terms of corporate quality right now, the system is going to implode like it did in 2007-2008 and the central banks need to be really wary about this.
Now, if you go back to December 2018, this was a warning sign. We think we got very close to a 2007-2008 episode again, all the signs were there. What you saw was the US dollar spiking, you saw tremendous demand for the government bonds, treasury bonds, credit spreads widened out, repo rates went up, Wall Street tanked. And then the Federal Reserve came in and made an announcement in January, calmed everybody down because it said it was going to rethink policy.
Now, that's really a very, very important statement. We don't know how the Federal Reserve is going to end its thinking, it's still thinking about how it does it. But the outcome is critical for not just US financial markets, but for world financial markets.
Where are we in the liquidity cycle now?
What you've got is a system creaking. The question is what are the shocks that it can take? Now, if you look at the world economy, look at it in context. The shocks that we used to see in the 1960s and '70s were oil shocks or labor costs shocks. The shocks we're seeing now, it's a shock to the whole global liquidity structure, the complex, and those little things that are unpredictable. And this is what central banks need to guard against.
So, the whole idea of doing QT, of sucking out this precious liquidity is extremely dangerous. And what they need to do is basically make sure the system has got enough liquidity to operate. And the question is, number one, has the Federal Reserve changed? Now, we originally thought in January, the statements they were making convinced us they probably had, they saw these threats. Okay? And the statements that Powell made were very incisive, I think.
If you look at what's happened since then, and you look at operations within the money markets, what the Fed's doing, they are continuing to suck liquidity out. There was a little bit a blip in late January, February, it's now come down again. Because basically, there are some structural impediments in the system, which means there is a shortage of liquidity because of a general lack of collateral.
But then what you've seen in the last, let's say, three to four months, is a tremendous inflow into markets, that's largely come from cross border investors. Okay? Now, this is very similar to what we saw in early 2016. The so-called Shanghai Accord. A lot of money came into markets, investors went risk on, markets rose for what probably a period of two years, I think, almost uninterrupted, and that was a good time to be risk on. We think this could happen again. You could see enough momentum coming through in this cross-border flows to actually push markets further up.
Therefore, our instinct is to say, looking at these indicators, we want to be risk on in this environment. But in the back of our mind, we've got this problem that you've got this potential crevasse in markets like December, when you get a problem. And when you get a problem, markets panic. And you see, we think, an environment where markets broadly drift outputs but very sharp spikes down.
Now, the critical question is- how do you asset allocate in that environment? And the one thing that you need in portfolios, if you are maintaining risk on is number one, to diversify out away from the US market where, particularly the Fang stocks, where most of the big increases have been seen out into markets, like Japan, like China, like probably Britain, which look we think undervalued in this context relative to Wall Street. And you need to have bonds in your portfolio. But particularly what you need is bond convexity.
And bond convexity, which is a wonkish concept I know is basically being able to participate in very big outsized move in the bond market. Now, are you going to get these outside moves? It's entirely possible. Okay, let's not rule this out. And what I would say is, what your viewers need to ask is, why have you got three critical prices, which are out of whack?
The first thing is you've got a negative term premium on the Treasury market. Okay? This is beyond unusual. It's just very, very rare. Okay? You don't see this very often. And turn premia are normally positive than negative. And what that's saying is that basically, people are prepared to own long-dated treasuries at a discount. There's a big demand, excess demand for treasuries.
The second thing is why US rates 250 basis points above other big markets? This is really strange. The US dollar is the safest asset in the world, the US Treasury market is the safest piece of collateral, and you've got yield premiums against everybody else, it makes no sense. Okay, something is being mispriced in the system.
And the third thing is, as I mentioned earlier, Wall Street's really the only equity place where you've got a decent bull market. Everyone else is flatlined pretty much over the last 18 months or so, even going down.
What's the relative risk in US markets?
Prudence would say you need to rotate into markets that have been left behind. There's a lot of value out there. And what you're seeing, I think, is more and more evidence that outside of the US, the world economy is stabilizing. So, that would suggest that investors are going to start to move more risk on. Now, one of the critical places to watch is China. Now, it's very interesting to see the move that you've seen in the Chinese market so far this year. We've had a view that China is radically undervalued given the longer-term prospects.
The curiosity is the market has basically convinced itself that the PBOC, China's People's Bank, is basically easing policy. They saw the commentary says they've injected huge amounts of money into the money market simply is not true. Okay?
There was a jumping credit in January. But that's a seasonal effect. That's a seasonal effect that always occurs in China in January, because of the Lunar New Year holiday. Once you take that out, essentially liquidity has gone down. And if you look at the daily operations of the People's Bank, right up to yesterday, what you see is that they've been progressively taking liquidity out.
Now, why is that happening? It's a head scratching moment, we're not sure. But I would argue it's all to do with the China-US trade talks. And the one thing that China cannot afford to let happen is the yuan- the Chinese currency- to devalue. Because once it starts to devalue, it can cascade, that can be a lot of money moving offshore. Now, the EU capital controls, the capital account is leaky. And that's a problem.
So, our view is that one of the things they've been doing is effectively maintaining a tight grip on the markets to try and make sure that the yuan is stable. And to do that, they've basically kept money markets on quite a tight leash. Now, once these trade talks are over, we would fully expect that you're going to see a lot more liquidity being thrown at the Chinese markets. What they will have to do is effectively restructure the economy, away from exports, much more towards infrastructure and domestic growth.
And if you look at the pattern that is being followed, our contention is this looks like the US attack on Japan in the 1980s. Looks very, very similar, ending with Super 301. And that's what effectively is going to happen in the case of the China-US trade talks. China will have to open up. The US will score a victory, and China will have to move more into domestic focus growth, which means infrastructure. To pay for that, the people's buying comes into play.
Is there a risk that markets have gotten ahead of themselves?
A lot of the money that's coming to market does not come from the Federal Reserve, as people would suggest, or from the People's Bank of China. It's effectively come from cross-border investors. This has been the big increase. And what you've seen in terms