When Tailwinds Become Headwinds

As we head into 2018, investors’ imaginations are filled with visions of blowoff tops, spectacular melt-ups, billion-dollar Bitcoin bonanzas, and tech rallies flying off into the wild blue yonder like an “unleashed” Icarus, whose wings refused to melt no matter how high he flew.

“Visions of sugar-plums danced in their heads”…

These are nice thoughts. This is what dreams are made off – literally. Target managers have quit their day jobs to make millions as armchair vol. sellers (without reading the find print on their ETPs). Mom and pop are allocating to illiquid junk bonds (without understanding the inherent liquidity mismatch). Passive investing has conspired with other indiscriminate flows to create a QE-like black hole for equities which, when combined with the proliferation of ETFs, creates a veritable perpetual motion machine. And E*Trade is running commercials about the dumbest guy in high school buying yachts (literally).


Meanwhile, the global upturn in growth is synchronous. Macro volatility is subdued. And inflation is still largely below target in DM economies. That creates the now ubiquitous “Goldilocks” backdrop where upbeat econ is used to justify being long risk assets and still-low inflation is trotted out as a rationale for why DM central banks will stick with a gradualistic approach to normalization.

What stops the party? What pops the bubble(s)? What shatters the dreams of the deluded masses? The common refrain is that a sudden upturn in inflation could lead directly to a policy shock as central banks are forced to withdraw transparency, causing rates vol. to spike, leading to a tantrum as stock-bond return correlations flip positive, the VIX ETP rebalance risk is realized, and Marko Kolanovic’s “quantitative exuberance” thesis is borne out as risk parity, CTAs, and other vol.-sensitive strats deleverage into a falling market.

Well, for their part, Nedbank’s Neels Heyneke and Mehul Daya want to talk about contracting liquidity. Specifically, four liquidity tailwinds that are set to either lose momentum or turn into headwinds in 2018.

First up, petrodollars. To wit:

Oil has been a major tailwind but has now reached our target level. The oil price has risen from $25 to the current $61 (+104%). This boosted $-liquidity and eased global financial conditions. Petrodollars can be described as the spending or investment of a oil-producing nation’s revenues (from oil exports) back into the dollar financial system. Higher petrodollar balances provides the world with dollar liquidity and eases financial conditions. In 2014 when oil prices collapsed, petrodollar balances fell into negative territory resulting in a shortage of dollars in the financial system. This was followed by a stronger dollar. The improvement in oil prices has resulted in positive petrodollar balances for the first time in two years, as well as in a weaker dollar in 2017. Even though the petrodollar balances remain well below historical levels, they have been supportive of financial markets.


This, the bank says, is the “last man standing” in terms of global liquidity tailwinds.

Next up is China, and the ever-present threat that Beijing’s efforts to rein in the country’s “mind-boggling” shadow banking complex will end up choking off credit:

The second liquidity tailwind what we believe will be negative for financial markets is the slowdown in credit creation in China. There is a strong relationship between the credit impulse in China and commodity prices. Credit creation in China has been slowing down and is set to slow down further (especially in the shadow banking system) as indicated by Chinese authorities at the 18th National Congress Communist Party of China. Higher commodity prices have provided the world with $-liquidity during 2016/17. There is a one year lead time between the credit impulse in China and commodity prices, this relationship suggests that commodity prices are likely to fall next year as a result of the slowdown in credit creation. A slowdown in commodity prices will not bode well for $-liquidity and financial conditions.


Moving right along, Nedbank touches on a familiar topic – the supply/demand distortion created by QE and the notion that it is not the stock of central bank asset purchases that matters, but rather the flow. Citi’s Matt King has been pounding the table on that latter point for years and on Tuesday, Bloomberg highlighted a Bank of England staff blog reiterating the idea that it is the ongoing support provided by incremental purchases that perpetuates the status quo.

Here’s Nedbank on the supply/demand distortion:

The third liquidity tailwind what we believe is losing momentum is the expansion of the Central Banks’ balance sheets. To put the Central Banks’ QE programmes in perspective: The Fed never exceeded the annual treasury net issuance (0.8X), whereas the BoJ QE was 3X bigger than net issuance and the ECB QE is currently 7X bigger than net issuance Of the $15 trillion in sovereign debt issued since 2010, two thirds have been absorbed by official purchases. These actions have distorted bond yields, the traditional forecasting ability of the yield curves, the pricing mechanism of the market, and risk premiums. As a result of these massive QE programmes, the Central Banks starved investors of assets and forced investors into other risk investments and into the infamous carry-trade. This benefitted EMs. In other words, it is not just the hunt for yield, it is also the hunt for assets that is driving the carry-trade.


“For asset price performances (especially risk assets), the rate of change in Central Bank balance sheets is more important than the stock,” the bank continues, before illustrating this point in much the same way Citi has previously:


Finally, to the fourth liquidity tailwind that will soon become a headwind:

The fourth liquidity tailwind what we believe will be losing momentum is the excess liquidity that the US Treasury Department indirectly provided. Since late 2016 there was a $400bn surge in dollar liquidity because the US Treasury was running out of debt issuance capacity to fund the US government’s expenditures. Hence it had to utilize its cash balances at the Fed for this purpose. As a result, otherwise idle cash reserves now entered the financial system. As a result of this liquidity injection by the US Treasury, dollar financial conditions eased and contributed to the risk-on phase since the start of 2017. However, going into 2018, the US Treasury will be required to replenish its cash balances by approximately $420bn. This should reverse the excess liquidity in the financial system and tighten financial conditions.


The upshot: as these liquidity tailwinds become headwinds, cross-asset volatility could rise, imperiling risk assets and going some ways towards turning the sweet dreams described here at the outset to nightmares.

Sleep well.






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