It’s summer, and the only liquidity we should be thinking about is a cold beverage on a warm beach. Summers in Seattle are way too short, and since the rainy season is always just around the corner we need to enjoy the sun while we can.
Despite the distractions offered by warmer weather, we are noticing some market developments that are far from bright and sunny. The first is liquidity and the second is debt, both of which were highlighted in a recent report produced by the Bank for International Settlements.
We often talk about how the Federal Reserve is raising the fed funds rates and reducing its balance sheet. This is draining liquidity from the capital markets and will likely eventually lead to lower economic growth and the next recession. As the old saying goes, “Economic expansions do not die of old age, they are murdered by the Fed.” We know we are well along in this cycle of interest rate hikes, and it is important to note the Fed is not alone in taking away liquidity. Many of the world’s central banks are also planning on raising rates, which will impact the U.S.
Higher debt levels are a second important issue. The financial crisis in 2007/2008 did not lead to lower debt levels as one would expect. As the crisis unfolded, central banks stepped in with aggressive liquidity measures to keep the world financial plumbing intact. Governments borrowed and spent with abandon to soften the recession, and corporations capitalized on ultra-cheap money to increase dividends, fund buybacks and make acquisitions. Only households modestly reduced debt directly after the recession. But some research suggests much of this debt reduction can be attributed to forgiveness of mortgage loans during foreclosures, not to debt repayment.
Note : AE = Advanced Economies, EME = Emerging Market Economies
So here we are trying to enjoy that cold beverage with the knowledge liquidity is draining, debt is piling up and the consequence will be more volatility and likely lower prices for risky assets. The good news is that as Seattle residents our rain jacket is always close at hand. We are currently positioning portfolios for more volatility by scaling back on credit risk, keeping liquidity high, and maintaining duration exposure close to home.
Enjoy the sun!
Sources: The Financial Times, Bloomberg, The Bank for International Settlements