Date: 14 February, 2019 - Blog
So far, the transition has proved benign…
The evaporation of extremely ample liquidity conditions, featuring the end of US financial repression, has proceeded – surprisingly – well so far. It actually took about three years for the Fed to restore ¨about-neutral¨ (nominal) policy rates, without causing serious disruption, be it in terms of economic expansion or financial markets. Since then, no recession, no bear market, no systemic crisis took place. Granted, a few inevitable accidents occurred, but essentially in the sphere of bubbly / speculative segments of the markets. And, importantly, this normalization, which started in Q1 18 with the ¨Vix-mageddon¨, has developed sequentially over last year, culminating with a rude landing of equity markets (and retail investors) last December.
The good news is that the complacency and several buckets of speculation have forcefully dissipated. The inevitable tightening of financial conditions has now reached a pause phase, courtesy of change of rhetoric from the Fed.
The weaning of liquidity-addict markets is reaching a tipping point
The Fed will be torn between two incompatible objectives: growth and financial stability
… but financial stability remains an open issue
Regulators and policy-makers worked hard in the last decade to build a safer banking / financial system. Namely, juggernaut banks have been forced to scale down their risky operations, as well as provide greater transparency and accountability. This seems good on the surface. But a consequential flip-side of this improvement is now surfacing: the liquidity ¨bumpers¨ coming from their market-making operations has dramatically waned. A new sort of disequilibrium is consequently emerging, as investment flows are growingly set by high frequency trading, Artificial Intelligence, and quantitative models / algorithms. Multiple flash crashes and the extreme volatility of last December testify for it…
US government’s unilateralism and the lack of skills / experienced staff goes along the same line. The bail out of banks / car manufacturers and the TARP programs, about a decade ago, were remarkable. There are serious doubts regarding the reaction function of the Trump administration, if a crisis was to unfold. Particularly so with a gridlocked Congress. European populism and Brexit represent additional sources of risks. These deep political fractures / divisions would inevitably complicate a common dealing in case of a practical crisis.
Shadow banking systems developed hastily in China in past years (but not only there…). They represent a new source of challenge for the central bank, as they allow economic agents to efficiently bypass financial restrictions, circumvent regulation if not contradict the stance of authorities on monetary / credit policies. It’s a bit like the story of the doped sports’ athletes being always one step ahead of the police.
The exponential rise of ETF popularity creates side effects. For instance, the broad access to leverage loans and high yield, via daily liquidity products, is practically dangerous. Indeed, lots of these underlying assets are quasi illiquid by nature. A serious mismatch would occur, with significant price deviations, when the eventual next crisis takes places.
Powell, Draghi successor and Mnuchin will, for sure, endure further probation in 2019/2020
Beyond banks, regulators should refocus on new financial structures and investment vehicles
- A likely new round of Reflation seems in the offing. Short-term that would support expansion and markets
- Such positive distraction would raise the odds of serious crisis, if long-term stability issues are not addressed
