In a somewhat unscientific way, we could suggest that risk markets have lost their ability to shrug off bad news and even economic disappointment (despite all of the hoopla, 2017 did not in fact live up to consensus expectations) and instead seem now to view any adverse news as a reason to sell. We believe that this sea-change in ‘attitudes’ has been brought about by a fundamental change within the credit environment within the financial system.

Specifically, last year’s rather mercurial release of the US government’s contingency reserve into the private sector economy created a surge in liquidity within the banking system that in turn resulted in an aggressive expansion of credit to the financial system by what was by all measures a relatively small number of lenders. These lenders provided funds both to the US’s domestic markets (thereby creating a particularly potent environment for the asset markets as there was a relative dearth of T bond issuance but a boom in private sector credit availability), and to overseas banks. The USD funding that was lent to foreign banks was without a doubt the cause of the weak USD last year, but also almost single-handedly reflated the banking systems of France, China and several other of the important Emerging Markets.

Certainly, we regard the expansion in the availability of wholesale USD funding as being instrumental in the revival in the global credit environment last year, an event that itself will have contributed to the global economic recovery story.

However, this cycle has plainly come to an end, not only as the Federal Reserve has begun to contract its balance sheet but also, and somewhat more importantly, as the Treasury has started to rebuild its fiscal reserves at the expense of private sector liquidity trends. In effect, not only is the Federal Reserve reducing the aggregate amount of base liquidity in the system, the Treasury’s actions are conspiring to ensure that the Government controls relatively more of this shrinking pool of liquidity. Naturally, this situation has resulted in a turn in the domestic and – importantly – the global credit tide that few in the mainstream markets may be aware has occurred, even now. Nowhere has this shift in credit conditions been more apparent than in the flow of credit to financial institutions with offices in the US.

USA: Bank Credit to Financial Sector

 USA: Bank Credit to Financial Sector

Rather ominously, we are reminded of the situation that prevailed during March-May 2000, when a number of seemingly obscure regulatory changes by the FRB resulted in a sharp reduction in the supply of credit to the corporate bond markets and we believe that it was this that finally derailed the Tech Bubble. On this latest occasion, the withdrawal of liquidity from the private sector banks that has occurred as a result of this combination of the Fed’s shrinking balance sheet and the more obscure Treasury Department’s increased removal of liquidity via a change in its deficit funding policy has resulted in a similar fundamental turn in the credit tide.

Just as we viewed the intense expansion of credit within the financial system last year as having been reason enough for the boom in risk assets that ensued (and the lack of weakness in the debt markets!), we view the current contraction in bank liquidity / bank credit as offering reason enough for the weakness in financial markets that has occurred since February (and the stronger USD of late).

Moreover, we would expect this negative bias for the markets from the liquidity situation to continue for a few more weeks before the Treasury (for largely seasonal reasons) can be expected to reduce or even cease its (net) withdrawal of liquidity from the private sector. If the Treasury does relent as we approach the third quarter, then the headwind facing markets could lessen.

In the short term, however, we must also wonder if the reversal in the liquidity tide will flow smoothly. Last year’s credit boom in effect took the ‘shape’ of an inverted pyramid in which the US Treasury provided the initial funding, in which only one or two US investment banks leveraged the resulting funds into a surge in wholesale funding that was in turn drawn upon by a dozen or so large global ‘mega-banks’, who in turn lent the money to a large number of ‘end-users’ in Europe and the EM. In practice, what started life as a simple deposit by the Treasury was transformed via the highly collateralized / short-duration repo markets into wholesale funding. These funds were then lent across borders and currencies at longer durations before finally being advanced as long-term domestic credit thousands of miles from their origin in countries that are not always renowned for their ability to service their debts…

This structure is inherently unstable. Presumably, there are relatively few people in the US Treasury who get to decide on the level of T bond issuance relative to the size of the US budget deficit at any given time. Similarly, there may then only be 10 – 20 people at the 1 – 2 key US banks that decide on whether and how much to lend. There are then maybe 100 people directing funds in the wholesale markets but, by the time one gets to the top of the structure, there are likely to have been thousands of bank lending officers and a myriad of actual and would-be borrowers. Clearly, this inverted pyramid of miss-matched durations, currencies and numbers has the potential to topple over if it is disturbed either by a quite major economic / political shock at the top (as are prone to occurring in EMs – particularly ones such as the PRC that are themselves already very highly indebted), or even a relatively minor tremor at its base (such as a shift in the Treasury’s funding policy…). Clearly, this is a vulnerable system, although it must be remembered that vulnerable systems do often survive.

This question of survival is of course the $6 trillion (or more) question for asset managers and the answer is - of course from an economist - maybe. What we do know, however, is that this system is becoming somewhat stressed at present.

For example, China’s central bank has recently been obliged to begin recapitalizing its banks via both bond sales to the PBoC and via a surprising but profit-friendly cut in the RRR. However, despite these helpful actions, we find that the share price relative of China’s banks has performed very poorly of late and this is usually a reliable indicator of mounting stresses in any banking system. Meanwhile, many of the foreign wholesale funds that were borrowed last year by China’s banks were of course rooted via the financial systems of either Hong Kong or Singapore. It is of course well-known that the HKD has been under considerable pressure of late, while the share price relative of Singaporean financials has performed quite poorly.

Next in the ‘chain’ were a number of large Japanese banks that aggressively ‘mined’ USD funding from New York and in turn provided the dollars to the Asian banks. The share price performance of these entities has been quite disturbing of late. Finally, we have the very base of the pyramid, we observe the US investment bank that was the primary conduit to the rest of the system for the liquidity that the Treasury was releasing in 2017. Despite some reasonable results, the share price of this particular institution seems to be hovering around a range that a chartist contact of ours believes makes it quite vulnerable.

Perhaps the bank shares in question will not decline further (we are being coy on its identity for PI reasons but we are sure that everyone has guessed the identity….) but, if we were to witness a significant decline in this price, we would then be able to point to what amounted to a ‘full house’ of signs of systemic weakness in the credit process that very few people are talking about but which formed one of the major drivers of asset markets and even real economic activity during 2017.

There are of course known unknowns present within the global financial system, the most prominent of which are the exit strategy / concentration issues associated with the BoJ and ECB’s massive balance sheets and their dominant positions in many bond markets (in a sense they have become the LTCM’s of the 2010s). Clearly, unwinding these massive portfolios is a challenging task that, if mishandled could prove disastrous (and even if the process is well-handled there will be adverse implications for bond prices, yields and the monetary data) but it strikes us that the more pressing threat to the global credit system is centred on the international credit pyramid that we have described here.

At the very least, it is our view that the Global Recovery / Global Funds Flow stories that so benefited asset markets in 2017 were in fact built on two primary events – a surge in China’s demand for imports (which still seems strong in an absolute sense but which is no longer accelerating) and a surge in global credit growth that was primarily based on a resumption in cross-border credit flows that may have ended in February. However, if we are correct in our view that the tide of cross-border USD credit has indeed begun to ebb, then the global credit creation system in general is likely to weaken – potentially quite significantly.

Total Global Credit in USD

 Total Global Credit in USD

Clearly, the risks to our global aggregate credit data chart currently lie to the downside and, as we have seen in the past, when the global credit tide ebbs within a highly leveraged, and in many places highly concentrated and narrow system, the effects on risk asset prices can potentially be severe. At the very least, the slowdown in credit trends should prove to be negative for global growth trends with the result that we have decided to pare back our short position vis-à-vis the fixed income markets and lighten our positions in risk assets, while at the same time favouring the USD in the currency markets. The disaster scenario may not – and will hopefully not – come to pass but at the very least it seems to us that the world environment is changing in a way that many were not expecting at the beginning of the year.