On the Cusp of a Global Liquidity Crisis
Is there a financial calamity worse than a severe recession in early 2023? Unfortunately, the answer is “yes” and it’s coming quickly.
That greater calamity is a global liquidity crisis. Before considering the dynamics of a global liquidity crisis, it’s critical to distinguish between a liquidity crisis and a recession. A recession is part of the business cycle.
It’s characterized by higher unemployment, declining GDP growth, inventory liquidation, business failures, reduced discretionary spending by consumers, reduced business investment, higher savings rates (for those still employed), larger loan losses, and declining asset prices in stocks and real estate.
The length and depth of a recession can vary widely. And although recessions have certain common characteristics, they also have diverse causes. Sometimes the Federal Reserve blunders in monetary policy and holds interest rates too high for too long (that seems to be happening now).
Sometimes an external supply shock occurs which causes a recessionary reaction. This happened after the Arab Oil Embargo of 1973, which caused a severe recession from November 1973 to March 1975. Recessions can also arise when asset bubbles pop such as the stock market crash in 1929 or the bursting of a real estate bubble caused by the Savings & Loan crisis in 1990.
Whatever the cause, the course of a recession is somewhat standard. Eventually asset prices bottom, those with cash go shopping for bargains in stocks, inventory liquidations end, and consumers resume some discretionary spending. These tentative steps eventually lead to a recovery and new expansion often with help from fiscal policy.
Global financial crises are entirely different. They emerge suddenly and unexpectedly to most market participants, although there are always warning signs for those who know where to look. They usually become known to the public and regulators through the failure of a major institution, which could be a bank, hedge fund, money market fund or commodity trader.
While the initial failure makes headlines, the greater danger lies ahead in the form of contagion. Capital markets are densely connected. Banks lend to hedge funds. Hedge funds speculate in markets for stocks, bonds, currencies and commodities both directly and in derivative form.
Money market funds buy government debt. Banks guarantee some instruments held by those funds. Primary dealers (big banks) underwrite government debt issues but finance those activities in repo markets where the purchased securities are pledged for more cash to buy more securities in long chains of rehypothecated collateral.
You get the point. The linkages go on and on.
The Federal Reserve has printed $6 trillion as part of its monetary base (M0). But the total notional value of the derivatives of all banks in the world is estimated at $1 quadrillion. For those unfamiliar, $1 quadrillion = $1,000 trillion. This means the total value of derivatives is 167 times all of the money printed by the Fed.
And the Fed money supply is itself leveraged on a small sliver of only $60 billion of capital. So, the Fed’s balance sheet is leveraged 100-to-1, and the derivatives market is leveraged 167-to-1 to the Fed money supply, which means the derivatives market is leveraged 16,700-to-1 in terms of Fed capital.
Experts say, so what? These numbers are not new and have been even more stretched at certain times in the past. Simply because the financial system is highly leveraged and densely connected does not mean it’s ready to collapse. That’s true. Still, it does mean the system could collapse catastrophically and unexpectedly at any time. All it takes to collapse the system is a shock failure leading quickly to panic.
Margin calls are issued on losing position and immediate payment is demanded. Overnight repos are not rolled over. Overnight deposits are not renewed, and repayment is required. Everyone wants his money back at once. Assets are dumped to meet repayment obligations, which causes collapses in stock and bond markets, which causes even more losses and liquidations among banks and traders.
Suddenly all eyes are on the Fed for easy money and on Congress for bailouts, guarantees and more spending. We’ve seen this pattern in 1994 (Mexico Tequila Crisis), 1998 (RussiaLTCM crisis), and 2008 (Lehman Brothers-AIG crisis).
Note that two of those three most recent financial crises were not accompanied by a recession. There was no recession in 1994 and none in 1998. Only the 2008 global financial crisis happened to coincide with a severe recession.
The point is that recessions and financial crises are both bad, but they are different and do not always come together. When they do, as in 2008, stocks can easily decline 50% or more. We may be looking at such a situation today. This brings us to the key question:
If financial markets are almost always highly leveraged but financial crises occur once every eight years on average, what signs can investors look for that indicate a crisis is coming and conditions are not just business as usual for financial markets?
One of the most powerful warning signs is an inverted yield curve. This signal was last seen in 2007 just ahead of the 2008 financial crisis. A normal yield curve slopes upward from left to right reflecting higher interest rates at longer maturities. That makes sense.
If I lend you money for ten years, I want a higher interest rate than if I lend it for two years to compensate me for added risks from the longer maturity such as inflation, policy changes, default, and more.
When a yield curve is inverted, that means that longer maturities have lower interest rates. That happens, but it’s rare. It means that market participants are expecting economic adversity in the form of recession or liquidity risk. They want to lock in long-term yields even if they’re lower than short-term yields because they expect yields will be even lower in the future.
In a nutshell, investors see trouble ahead.
Other ominous signs include sharp declines in the dollar-denominated reserve positions in U.S. Treasury securities of China, Japan, India and other major economies. Naïve observers take this as a sign that those countries are trying to “dump dollars” and dislike the role of the dollar as the leading global reserve currency.
In reality, the opposite is true. They’re desperately short of dollars and are selling Treasuries as a way to get cash to prop up their own banking systems.
These are some of the many signs pointing to a global liquidity crisis. As we’ve learned in the past, these liquidity crises seem to emerge overnight, but that’s not true. They actually take a year or more to develop until they hit a critical stage at which point, they burst into the headlines.
The 1998 Russia-LTCM crisis started in June 1997 in Thailand. The 2008 Lehman Brothers crisis started in the spring of 2007 with reported mortgage losses by HSBC. The warning signs are always there in advance. Most observers either don’t know what the signs are or are simply not looking.
Well, I am looking and what I see is a rare convergence of a severe recession and a liquidity crisis at the same time as happened in 2008.