When a picture chart says a thousand words:
That’s from Goldman Sachs’ 2020 macro outlook report entitled “learning to fly without the Fed”.
The analysts note that risky assets benefited from central bank easing in 2019, but now growth will need to drive returns. But while they say global cyclical signals are looking slightly better — and the bank’s economists forecast sequentially higher growth in most regions — it’s unlikely to be the type of go-go global growth environment that would sink the dollar or result in a major bear market for bonds.
The real reason markets will need to learn to fly on their own in 2020, according to the analysts, is because major central banks will have no choice but to keep policy unchanged because in some cases they have nowhere else to go.
With respect to central bank limitations, the report also addresses September’s repo panic.
The analysts agree the incident shows that a post-crisis deterioration in market liquidity conditions remains “a major source of vulnerability for investors”
In that respect, they offer an interesting observation about dollar roll transactions (our emphasis):
For fixed income investors, particularly in less liquid markets like corporate credit or mortgages, episodes such as the one experienced in the repo market offered yet another valuable lesson: putting a price on liquidity risk has rarely been more challenging. Unsurprisingly, investors have responded by demanding a higher premium against liquidity risk. In the relatively liquid agency MBS market, the steady spread widening throughout the year has partly been driven by a gradual increase in the liquidity premium. This repricing reflects the strong reliance of the “To Be Announced” (TBA) agency MBS market on so-called Dollar roll transactions. The same forces that have fuelled stress in the repo market have also increased the costs of financing TBA trades.
As the footnote explains about dollar roll transactions:
Technicalities aside, a mortgage Dollar roll financing transaction for an MBS pool owner seeking financing involves simultaneously selling the pool in the current front month (say, December 2019) and buying back the same face value of pools in the subsequent forward month (eg, January 2020), with the front and forward delivery prices both determined on the date of the Dollar roll trade. The Dollar roll transaction is similar to a standard repurchase agreement; however, in a Dollar roll: (a) the roll buyer providing financing receives the interest, scheduled principal and principal pre-payment cash flows associated with the pool during the financing period; and (b) the pool that is repurchased in the forward month is not identical to the pool initially delivered, although is similar in terms of having equivalent coupon, original maturity and issuer.
The point here is that while the two legs of a dollar roll are identical in terms of the core variables that matter, their constituents can be different. That means for rolls to happen smoothly, these supposedly simultaneous transactions still need access to plentiful market liquidity to execute the switchover. No liquidity, no rollover. Tight liquidity, and the switchover will cost more than previously envisioned, potentially impacting positions previously deemed unconstrained.
Which illustrates a key vulnerability in our increasingly capital markets-dominated liquidity-providing system. Without the presence of a credit-providing intermediary to bridge the two legs, counterparties in these sorts of trades are entirely exposed to liquidity conditions. One reason, no doubt, too-big-to-fail banks ended up intermediating these sorts of market imbalances by way of the tri-party repo system.
It’s an interesting point in the context of the intraday liquidity demands being imposed upon the system by real-time gross settlement (RTGS) transaction expectations more widely. As we’ve argued before, the move towards RTGS systems among the world’s most important central banks has introduced an under-appreciated liquidity pressure on the system. As the architects of these systems warned, for real-time (effectively simultaneous) settlement to occur without risk of gridlock, the system would require unrestricted access to intraday liquidity on a pretty much no-questions-asked basis.
But to keep the system in check, many central banks (although not at the Fed) determined a constraint, in the form of a collateral pledge, was still needed.
Carolyn Sissoko, economics lecturer at the University of the West of England, recently made an extremely well articulated observation in connection to this matter in an analysis and critique of the main academic theories about the factors driving financial instability risk in the system.
With respect to the liquidity based view of risk as presented in the work of economist John Cochrane she notes (our emphasis):
In short, Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it.
But the key point is this:
. . . the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.
This is a fantastic point. The presence of credit-providing banks (which have the capacity to net off exposures between them) allows the system to make gigantic liquidity savings, which otherwise would not be made in a capital-markets exclusive system.
And that by and large is a function of a trust-based financial system. Trust spares the system liquidity. Since banks trust each other, they don’t need to liquidate everything to the full gross level just to execute transactions that ultimately only change the composition of wholesale asset ownership or custody on a marginal basis.
Capital markets simply don’t offer the same scale of trust. In that respect should we really be surprised that central banks are now being forced to step in as trusted go-betweens (at all almost every transaction level) to ensure the increasingly capital markets-dominated system — which ironically was supposed to bring in more price discovery not less — can function without falling victim to liquidity gridlock?
What we need to ask ourselves at this point is what happens when central banks move from being intermediaries of last resort to intermediaries of first course, and via that process the entire asset market itself?
Related links:
How RTGS inadvertently killed system liquidity - FT Alphaville
How RTGS killed liquidity: US tri-party repo edition - FT Alphaville
Repo: How the financial markets' plumbing got blocked - FT
https://www.ft.com/content/3de72d99-4dd3-4661-bd25-31f1f044cfa2
2019-11-27 09:27:00Z
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