Bonds Look Dangerous. Could Global Liquidity Skid Lower Or Pause?

Hold on tight. Markets could suffer a near-term shake-out as Global Liquidity skids in the wake of deteriorating collateral markets. In contrast to the 2008 GFC, duration risk outweighs credit risk. US Treasuries, in particular, face growing pressures. Watch US Treasury yields closely. Prices are vulnerable to a further sell-off and persistent volatility. As a result, expect some correction in this unfolding bull market in risk assets.

Main Points

·         Global Liquidity has been a key driver of risk assets, but it is starting to skid

·         Problem is NOT tightening of liquidity by Central Banks, rather

·         Collateral pools are wobbling in wake of Japan’s YCC change

·         US Treasury markets face growing challenge from domestic coupon calendar

Falling Liquidity, Rising Stress

Markets never move in straight lines. The rebound in risk assets largely enjoyed in the wake of last September’s British gilt market (sovereign debt) crisis is facing its first major test. US Treasuries are under attack from all sides and although we remain sceptical of a direct linkage between bonds and equities, we cannot deny the fact that a weak and volatile bond market may disturb collateral pools enough to cause Global Liquidity and, hence, stock markets to skid.

Yet, this is unlikely to be the end of this bull market, which we foresee lasting well into 2025. Markets never move in straight lines and they are vulnerable to even a temporary deterioration in Global Liquidity. Since the 2008/09 Global Financial Crisis (GFC), liquidity provision has depended upon generous Central Banks and private sector credit that rests on a stable pool of collateral. Fluctuations in either of these twin pillars can cause Global Liquidity to sink. We argue below that, despite the misguided yet widely held view that Central Banks are still aggressively pursuing QT (quantitative tightening policies), it is wobbling collateral support that currently looks the most fragile pillar.

Figure 1 highlights daily movements in our US liquidity stress index. This combines selected data that measure the capacity of both Central Bank and private sector credit provision. The index which has been elevated throughout this US Fed tightening cycle, spiked higher during recent crises, such as the September 2022 British gilt sell-off and the March 2023 SVB failure. It is now starting to pick-up once again signalling growing liquidity tensions, after falling sharply when the US Fed responded swiftly to SVB.

Figure 1: US Liquidity Stress Index, 2021-23 (Daily, Index 0-100)

Source CrossBorder Capital, US Federal Reserve