Tranquility reigns over markets still awash with cash, for now

LONDON — Soaring interest rates, slowing economic growth and a banking sector still recovering from a March rout might suggest a note of market caution, yet world stocks are at 14-month highs, the S&P 500 stock index has entered a bull market and gauges of volatility are eerily calm.

For some, the answer to exuberant markets lies in the ample cash still sloshing around the financial system. But it may not last, especially with the US Treasury potentially set to drain funds and risk appetite from markets with a surge in bill issuance.

BNP Paribas estimates excess global liquidity has risen by $640 billion since the end of third quarter of 2022 and is “unsustainable” when some central banks are trying to offload bonds they hold in a process known as quantitative tightening.

As the second half of 2023 approaches, a more challenging environment could emerge for risk assets currently benefiting from ample liquidity.

OK FOR NOW?
For the short term, at least, analysts expect risk assets to remain buoyant.

The US Federal Reserve in March loosened financial conditions with an emergency credit facility for cash-starved banks, Japan’s central bank is still buying government bonds to push money into the system, and the European Central Bank is selling down the government bonds it holds at a relaxed pace.

Crossborder Capital founder Michael Howell notes “Japan is creating liquidity,” while “we expect more Chinese (monetary) easing.”

Total global liquidity, a measure of cash and credit in the world economy, has risen to almost $170 trillion in June, Crossborder calculates, from $158 trillion in October.

Central banks have added a net $1.7 trillion into money markets since November, it also estimates, a move that correlates with a risk-taking trend.

World stocks have gained 11% year to date, bolstered by US tech stocks rallying on an AI boom. The VIX index, a measure of implied volatility dubbed Wall Street’s “fear gauge,” last week hit its lowest since early 2020. A gauge of expected choppiness in US Treasuries is near levels last seen in February.

WILDCARD
Liquidity has “lots of moving parts,” said Richard Clarida, a former Federal Reserve vice chair and now a global economic advisor at bond fund PIMCO. He said the US debt ceiling deal could be a “wildcard,” depending on who buys a wave of new bonds.

The US Treasury is set to rebuild its general account by issuing $1 trillion or more of short-term bills, potentially at rates appealing enough to suck cash out of riskier assets.

This may also crimp banks’ ability to lend as they raise deposit rates to compete with T-bills, reducing the flow of credit to corporations and consumers.

Invesco’s head of multi-asset Georgina Taylor, said the firm has prepared for the drain by keeping a long position on the dollar, which typically benefits when investors turn more cautious.

But an alternative scenario is that US money market funds, stuffed with cash after depositors fled regional banks in March, buy enough newly issued Treasuries to keep rates stable.

Their cash tends to go into reverse repos, a Fed facility that offers generous rates for parking money overnight, and may move into T-bills instead, said Ken Taubes, chief investment officer Amundi US.

This shift of money “basically from one government pocket to another,” said Mr. Taubes, is “one of the reasons the markets are somewhat benign around this issue.”

WARNING LIGHT
BNP Paribas said its base case is for global liquidity to fall 6%–9% by end-September and 7%–11% by yearend, but liquidity is not the only reason behind the current upbeat sentiment.

“Liquidity is not a force that reverberates immediately into financial markets,” said JPMorgan global market strategist Nikolaos Panigirtzoglou.

As well as the AI boom, strong balance sheets and abundant cash at tech megacaps like Apple are attracting investors to these stocks, which dominate global equity indices.

Nonetheless, Morgan Stanley said in a note it was sticking with a bearish view on stocks given expectations for an earnings recession, and Pictet Asset Management’s chief strategist Luca Paolini said he was “underweight” equities and buying government bonds in anticipation of a credit squeeze and ensuing recession.

“There is a lot of money in the world and every time we see positive (economic or earnings) surprises, people put this money to work,” Paolini said. “But there are strong risks the market is ignoring, so we are still positioning for weakness in risk assets.” — Reuters