The Liquidity Threat Is Real

The root cause of the Great Financial Crisis can be summed up in one word. Insolvency.

Unfortunately, when U.S. subprime mortgages and derivatives imploded, investors panicked and financial markets seized. Yet almost a decade has passed, and insolvency remains.

It’s been hidden this whole time – by liquidity.

It’s the reason central banks are reluctant to “normalize” monetary policy. When the world is faced with rising interest rates, liquidity will recede and insolvency will be exposed.

Surely, we all remember the European sovereign-debt saga.

It taught us how liquidity can drive down the risk premium on financially fragile countries like Greece, Spain and Italy. It seemed the risk of lending money to those sovereigns was a lot lower than it really was.

Clearly, that wasn’t true.

And investors faced that sobering reality when those premiums blew open and when sovereign debts traded more appropriately with the underlying risk they carry.

Years later, the financial markets could crack with even the slightest policy miscue by the European Central Bank or the Federal Reserve.

Bank of America credit analysts are on the case. They point out that liquidity is not what it once was in the corporate-debt market.

In the past 10 years, trading volumes in corporate debt have gone up. But volumes as a percentage of total market fell from 135% in 2006 to 86% this year.

This means easily traded bonds make up a smaller portion of the debt that investors are holding.

And that’s because easy money and low interest rates sent investors in search of returns in riskier assets.

Investors feel safe seeking out less-liquid – aka, riskier – bonds to secure returns. As a result, there’s not much difference in how the market is pricing the risk between more-liquid and less-liquid debt.

Current option adjusted spreads (below) are way below historical averages.

Bloomberg Barclays. Indexes representing the investment types are: Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High Yield), Bloomberg Barclays Emerging Market USD Aggregate Index (Emerging Market USD Aggregate), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade). Data as of Aug. 18, 2017.


That sounds a lot like the European sovereign-debt crisis, doesn’t it?

Going forward, liquidity in the corporate-debt market might not be a problem.

If policymakers can keep interest rates low and asset purchases intact, it’s probably business as usual.

But if they can’t or don’t, then rising interest rates will shake up corporate debt.

Worst case: The global financial system could freeze up the way it did in 2008. At the very least, there would be isolated crises where debt is most precarious.

Look no farther than Europe …

In Italy, 18% of loans are non-performing. Martin Weiss recently visited Italy and filmed a short video outside UniCredit Banca in Milan. He returned with a warning: Italy could be the epicenter of the next global crisis.

Across Europe, non-performing loans (NPLs) still amount to 1 trillion euros and the ratio of bad debt is 5.5%. That’s double the ratio in the United States.

Unlike the Fed, the ECB uses its quantitative-easing program to buy debt of European companies. A cool 600 companies, to be exact.

Bank of America classifies 50 of those companies as “zombies” because they pay too much interest relative to their profits. They’re in trouble when the ECB tapers its purchases and interest rates begin rising.

The ECB told us last week they’ve begun discussing how and when to taper their asset purchases. Does that mean they’ll also entertain benchmark rate hikes? Will the market anticipate the inevitable by driving rates higher?

European high-yield spreads have tightened to levels not seen since 2007. High-grade corporate bonds are also near extreme lows. Overall, corporate net debt-to-GDP has risen from 92% to 104%.

From just a valuation standpoint, it doesn’t seem like European corporate debt of any grade is worth the risk.

Systemically speaking, European debt has the potential to spark another global crisis if policymakers can’t keep hold of interest rates expectations.

Markets are behaving as if policymakers have everything under control. But if liquidity disappears, all bets are off.

Do right,
JR Crooks

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Comments 5

  1. Glenn Melcher October 10, 2017

    Thank you for sharing this candid insight.. Have we not seen this before..


  2. Jay September 17, 2017

    what happens to the dollar when the EU collapses? At the moment the dollar is going going down vis a vis the euro or the pound. If the Dow is bought 2018 will the value tank when the dollar goes down; it certainly seems to be happening to the value of gold always in dollars but bought in euros


  3. Stephen Ettinger September 16, 2017

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  4. Dirk Breugelmans September 16, 2017

    Mr. Crooks,

    Congratulations with your article, i am living in Belgium so 99.9 % of the Europeans are not aware of this systemic problem.
    Peter Praet (ECB) this weekend in “de tijd ” (our financial newspaper) i quote ” most of the people are not aware what we dit , we lived in an entirely different world !

    kind regards,
    Dirk Breugelmans
    Prov. Anwerp


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