Politicians around the world would be happier if persistent inflation could be brought under control without triggering a recession or market shocks.
Unfortunately, in the real world, it rarely works that way. With elections looming in the United States and France, and with leadership challenges elsewhere, threading the needle of non-inflationary growth will be problematic. A more restrictive monetary policy will also lead to significant risks for financial managers.
Liquidity is not just an abstraction in the economic models of central banks. It is also the assurance that small savers and investors can easily access the assets in their accounts. Low-cost, high-speed electronic marketplaces for mass investors have created the illusion in recent years that assets can always be valued, traded or cashed out in fractions of a second.
Most are unaware of the transaction fees incurred by asset managers and traders. Hedging, or managing trading costs, becomes costly when markets crash or, for a while or months, crashes. If you’re managing a huge balance sheet or directing vast order flows, both types of mergers are dangerous.
“Risk is coming back strong this year,” says Pascal Blanqué, deputy chief executive and chief investment officer of Amundi, the €1.8 billion asset management company. “Liquidity is asymmetric, and now it is disappearing when it is most needed. We must therefore be prepared to manage liquidity mismatches at the fund level.
It is a complex task. The risk of not being able to buy or sell on demand will no longer be covered by central banks.
With the challenges ahead for the markets, some of the US mega asset managers are setting up internal pools to match client buys and sells where possible. So far, Amundi hasn’t taken that step, but Blanqué says it “calibrates liquidity risk more carefully at this time.”
“Even after the events of March 2020 [the Covid crash], oblivion in the markets always comes back, and most people are complacent again,” he says. Today, however, Western central banks and treasuries are far less willing (or able) to rescue institutions, markets or investors. There is simply too much official debt to manage in times of high inflation.
We now come to the delicate part of what Blanqué calls “this conjuncture”. Political leaders want inflation to disappear either quickly (Democrats, thinking of the 2022 election) or slowly (Republicans, thinking of the 2024 election). However, the likely cost of suppressing inflation is a hard sell, that is, a multi-trillion dollar reduction in the Federal Reserve’s balance sheet accompanied by a recession.
If the Fed sells assets to reduce its balance sheet, the trillions of official and mortgage debt it has accumulated must be bought by someone, first the primary traders or the big banks. In a world of low inflation and low interest rates, that’s not a problem. But in a rising and inflationary world, dealers can be stuck with large depreciating ex-Fed assets before they can successfully sell them to institutional investors or retail investors.
They are funding this, however briefly, with the Fed’s dealer repo capability, an arrangement to lend against acceptable high-quality securities. “Warehousing” government bonds in this manner was a loss leader during the era of quantitative easing support programs for Fed markets. Interest rates were too low to leave much room for concessionary banks.
That’s about to change. Let’s say, for the sake of argument, that the Fed finally raises the benchmark federal funds target rate to 1% in three or four moves.
This means that the dealer can store a bond position with a 1% coupon with a cost of debt to fund it that is at least 25 basis points lower. And all this against risk-free counterparties, i.e. the Treasury and the Fed. Banks can take the market risk of intervening in Fed deleveraging if margins are higher than they are now.
But then they have less balance sheet available to fund other assets, such as corporate capital expenditures or the easy buying and selling of other securities in those giant asset management companies. And the real economy and stock prices are expected to contract.
No wonder I got a letter from JPMorgan Chase asking me and my little US checking account if I wanted to be a private banking client. Thanks to the Fed, banks can once again earn money on deposits. But that will be paid for by a recession.