Central banks lay liquidity trap for stock markets

Liquid diet. Less money, more problems. Central banks may have unwittingly contributed to the Aug. 5 “mini crash” in global equities by taking $200 billion of cash out of the global system in the preceding days. Ratesetters had reasons to do so, but the risk is that liquidity traps could ensnare markets again.

Bad U.S. economic data and margin calls on debt-fuelled bets against the Japanese yen have taken the rap for a brief but sharp summer rout in world stock markets. But something else was going on in the background.

U.S. Fed Chair Jay Powell and his peers use injections or withdrawals of “reserves” – or money they create – to control interest rates, meet banks’ needs for cash and generally oil the wheels of global finance. Examples of these processes include the quantitative easing programmes. They involve creating reserves, boosting the amount of money in the financial system. The reverse, and currently widespread, process known as quantitative tightening, involves destroying that liquidity.

The day before the Aug. 5 crash, central banks in the United States, Europe, Switzerland, Japan and China collectively yanked more than $200 billion from the financial system compared to the previous seven days, according to an analysis by Matt King of Satori Insights. Each central bank has different objectives, so the move was likely coincidental rather than coordinated. But the lack of liquidity may have deepened the plight of investors scrambling to raise cash for margin calls. At the very least, the episode underlines stock markets’ vulnerability to the otherwise arcane topic of central banks’ balance-sheet management.

Admittedly, it’s not a perfect relationship. Markets didn’t tank the last time ratesetters sucked an unusually large amount of cash out of the system, back in April. And a broader measure of liquidity compiled by CrossBorder Capital, which also includes private sector credit and bond markets, didn’t show any red flags in early August.

Still, two factors suggest the fragility may reoccur. The first is the size of central banks’ balance sheets, which have grown exponentially since the Fed and others rescued the financial system in the 2008 crisis. The Fed had $870 billion-worth of assets back then. It now holds $7.1 trillion. The second is investors’ herdlike penchant for following existing market trends. Over the past decade, this “momentum investing” style has been the world’s second-best performing strategy, according to MSCI. That has led to ever-more concentration in popular sector and stocks, which then magnifies losses when the trends reverse.

Since 2008, central banks have repeatedly come to the rescue amid market panics. Recent evidence suggests they may be causing them.

Context News

The U.S. Federal Reserve, the European Central Bank, the Swiss National Bank, the Bank of Japan and the People’s Bank of China, took more than $200 bln out of the global financial system on Aug. 4, according to calculations by Satori Insights. A day later, stock markets around the world plummeted, with Japan’s Topix index losing 12% in a single day, while the S&P 500 index closed down 3%.