Thirteen and a half years ago, at the end of 2008, the US FED kicked off on one of the most debated experiments in financial history: public sector quantitative easing. With policy rates at the zero-bound, injecting liquidity directly into the financial system through large scale asset purchases, the aim of the FED was to reliquefy the banking system thus enforcing a reversal of the extreme credit crunch that threatened the functioning of the economy. The central bank liquidity surge instantly sparked liquidity creation by the private sector. Indeed, the non-financial sector received a green light and debt capital markets kicked into higher gear, providing funding across credit sectors. Banks were brokering the credit starved corporate sector successfully. This blueprint inspired DM central banks over the following decade. Global liquidity got in a permanent state of excess. Over March 2020, as the global pandemic erupted, liquidity provisioning went in overdrive as, next to central banks going all-in, governments provided helicopter drops in the shape of several income supporting initiatives for households. In hindsight, central banks have been late to withdraw the liquidity added over the past 2 years. Yet, the effects of overstimulation represented by an overheating labour market next to out-of-control inflation as we leave the pandemic behind us, need to be addressed.
Eventually, as a synchronised monetary tightening cycle by EM (started over 2021) and DM (started over 2022) central banks is gaining pace, the risk of tumbling from liquidity pains into a liquidity crunch increases.
The question we have to ask ourselves is whether we have correctly assessed the impact of rising global liquidity pains that started to unfold in early 2022? What are the chances exactly that liquidity pains morph into a liquidity crunch? Because the moment we fall into a liquidity crunch, a credit crunch is not that far away. In order to do so, let’s briefly reflect on the indicators that impact global liquidity conditions.
First, the main indicator to measure global liquidity or the ease of financing is dependent on the level of short-term interest rates. Over 2021, EM economies pre-emptively kicked off a policy rate hiking cycle that continues till today. DM central banks followed over Q1 2022. Current market pricing sees DM and EM central banks reach terminal rates around the summer of 2023. Some EM markets show evidence of easing over 2023. For the FED & ECB, high-end estimates sit at 3.5% and 2% respectively. Rules based monetary policy (Taylor rule or deviations thereof) is not fit for purpose in a debt-laden global economic setting. Such rules, even based on defensive core inflation readings, still require policy rates to rise about 1.00% above the high-end estimates mentioned, towards 4.5% in US and 3.00% in Eurozone. Really? Yes, Taylor rule calculations give rise to such terminal rates putting in core inflation at target, leaving unemployment around current levels of 3.6% in the US and 6.8% in the eurozone. Even if markets price policy rate normalisation by the summer of 2023, it is still hard to predict how markets will behave when central banks do adjust with 50bp or 25bp increments.
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