The War on Liquidity

March 14, 2016

5 minute read

The War on Liquidity

by Ashish Shah, CIO, Global Credit, and Head of Fixed Income, AllianceBernstein

As policymakers try to support the real economy and protect the banking system, they’re unwittingly conducting a war on market liquidity. We think this approach ensures they won’t achieve either of their stated goals.

The Bank of Japan (BoJ) recently joined Denmark’s Nationalbank, the Swiss National Bank, the European Central Bank (ECB) and Sweden’s Riksbank in adding negative interest rates to the offensive—with the ECB moving more negative again last week. This is a major escalation with dangerous consequences.

In order to successfully support sustainable growth and a sound banking system, policymakers must do a better job of coordinating their regulatory and monetary policies, or they risk creating their own serious crisis.

Brave New World

Following the downfall of Lehman Brothers in 2008, central banks started using unconventional monetary policy, launching large-scale quantitative easing (QE) programs. By effectively lowering “risk-free” interest rates, these programs encouraged investment in corporate bonds and stocks—which resulted in a corresponding rise in stock prices.

At the same time, policymakers developed a profusion of regulations aimed at preventing a repeat of the 2008 banking crisis. At the heart of these regulations were the raising of capital requirements and the limiting of risk-taking by banks.

Investors complied with policymakers by growing their stock and credit allocations. But, like banks, they too pursued strategies that limited the additional risk in their portfolios—by selling those investments if markets began to decline. The unfortunate side effect of such strategies was an increase in the demand for market liquidity during periods of market stress.

Meanwhile, banks had responded to the new regulations imposed on them by withdrawing from their historical role as short-term providers of liquidity to the capital markets. The result? Not even the US Treasury market was spared periodic liquidity vacuums.

The first shot had been fired in the war on liquidity.

New World, New Risks

While QE has helped the world avoid a deep and protracted slump, it has neither delivered strong and sustainable economic growth, nor banished the specter of deflation. With new threats looming—weak emerging-market growth, a possible hard landing in China—central banks have identified a radical solution.

Negative interest rates appear to be a desperate bid to underpin inflation expectations, preserve the credibility of inflation targets and prevent exchange rates from rising. What is the probability of success?

Double, Double, Toil and Trouble

We doubt they will achieve these broader aims. Although negative rates have helped drive bond yields unnecessarily lower, negative-rate policies could derail growth and endanger banks’ very existence.

Negative policies essentially use the same three monetary-transmission channels as QE: the exchange rate, asset prices and bank lending. And all three of these have problems.

The exchange-rate channel is tough when you’re trying to be effective, because other central banks are employing similar strategies. Witness the recent sharp rise in the yen in response to the BoJ’s negative rate shift. Remember that the BoJ was hoping to steer the yen into a gentle decline.

The law of diminishing returns holds that investors will question their ability to manage asset volatility in a declining liquidity environment, and as more and more investors exit the market, volatility will climb.

“Neither a borrower nor a lender be” doesn’t really work for banks. Ultra-low to negative interest rates impinge on banks’ net interest margins, a critical component of banks’ future capital base. Combined with the impact of even more stringent regulation, this reduces banks’ willingness to lend to borrowers and further impairs banks’ already impeded ability to provide liquidity to markets.

Negative interest rates simply aren’t the effective tool policymakers wish them to be. Instead, they’re unwieldy, unpredictable and even dangerous. The risks of collateral damage to the financial markets—whether through erratic outcomes such as volatile currency markets or market liquidity seizing up—are simply too high.

The question then becomes whether there is an alternative. We believe there is.

Central banks: Lay down your arms. The war on liquidity must stop. Come together in coordinated deescalation across monetary and regulatory policies. Without coordinated efforts to sustain growth, avoid deflation and safeguard the global banking system, you may have nothing left worth fighting for.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

A version of this blog was originally published on CNBC.

Chief Investment Officer—Global Credit; Head—Fixed Income

Ashish Shah is Chief Investment Officer of Global Credit and Head of Fixed Income for AB. He is also a Partner of the firm. As CIO of Global Credit, Shah oversees all of AB’s credit-related strategies, including all global and regional investment-grade and high-yield strategies. In this capacity, he leads AB’s internal Credit Research Review Committee, the primary investment policy and decision-making committee for all credit-related portfolios managed by AB. As Head of Fixed Income, Shah is responsible for the management and strategic growth of the overall business. He is the author of several published papers and blogs, including those highlighting high-yield bonds as attractive substitutes for equities (June 2015), concerns around the bank loan market (November 2013) and the dangers in reaching for yield in the high-yield market (August 2013). Shah joined AB in 2010 as the firm’s head of Global Credit. Prior to that, he was a managing director and head of Global Credit Strategy at Barclays Capital (2008–2010), where he was responsible for the High Grade, High Yield, Structured Credit and Municipal Strategy groups and the Special Situations Research team. From 2003 to 2008, Shah was the head of Credit Strategy at Lehman Brothers, leading the Structured Credit/CDO and Credit Strategy groups and covering the cash bond, credit derivatives and CDO product areas for global credit investors. He holds a BS in economics from the Wharton School of the University of Pennsylvania. Location: New York

Chief Investment Officer—Fixed Income

Douglas J. Peebles is Chief Investment Officer of AB Fixed Income. He is also Co-Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios, and Lead Portfolio Manager for AB’s Unconstrained Bond Strategy. In his role as CIO of Fixed Income, Peebles focuses on AB’s fixed-income investment processes, strategy and performance across portfolios globally. He is also responsible for supporting the firm’s global distribution efforts and focusing on its strategic relationships. Additionally, Peebles pioneered AB’s highly successful and innovative approach to global multi-sector high income investing in 1997, which is just beginning to be adapted by other firms. He has held several leadership positions within Fixed Income, including as director of Global Fixed Income, from 1997 to 2004, and as co-head of AB Fixed Income, from 2004 until 2008. Peebles joined the firm in 1987. He holds a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York