– Amit Nath
“Earnings don’t move the overall market, it’s the Federal Reserve…focus on the central banks, and focus on the movement of liquidity…most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets” – Stanley Druckenmiller (2015)
The above quote is sure to resonate with observers of current markets and central bank actions, however Stanley Druckenmiller made the comment more than half a decade ago in 2015. Drukenmiller was actually responding to a question regarding the most important lesson he had learned in his career, he responded resolutely that it was an understanding of market liquidity.
For those unfamiliar with Stanley Drukenmiller, he identifies as a macro trader (not an investor) but is probably the best performing money manager of all time, with a 30 year track record over which he compounded capital at >30% p.a. and only had 5 down quarters out of 120 over that time. Perhaps most famously, he is credited with being the chief architect behind George Soros’ $1.5 billion bet against the British pound, which brought the Bank of England to its knees in 1992.
Drukenmiller is clearly well credentialed to be discussing market liquidity and the machinations of financial market supply and demand, hence when he gave a rare interview at the Economic Club of New York on May 12, 2020, the Montaka Global research team tuned in keenly to hear his views the current environment. As readers will likely know, many of Druckenmiller’s perspectives from that interview have already been splashed across the pages of financial press including his statement that “the risk-reward for equity is maybe as bad as I’ve seen it in my career”, the prospect of a V-shaped recovery in the U.S. is “a fantasy” and central bank and government stimulus programs weren’t building future growth.
However, what caught our attention in the interview and has received far less coverage, were Drukenmiller’s thoughts around the abrupt change that is occurring in macro liquidity (hence our opening quote). Drukenmiller highlighted the potential for a liquidity vacuum as the U.S. Federal Reserve slows its bond buying programs just as the U.S. Treasury accelerates issuance. This would effectively mean the liquidity tide we have seen since March when the Fed commenced it’s “unlimited” purchase program, would start going out to sea, and leave behind a more organic price discovery environment in markets, with potential for significant volatility relative to current levels in the market.
As a background, since March, the U.S. Federal Reserve has been buying more U.S. Treasuries (USTs) than the U.S. Treasury has been issuing securities (i.e. USTs). It has therefore been supplying cash to the aggregate pool of investors who sell their USTs to the Fed and then need to move these funds into an alternate markets. While much of the evidence points to equities being a key beneficiary of these capital movements, commodities, fixed income or reinvestment back in other USTs may also serve as a viable home. To put numbers around what we have seen, over the last ~2 months, the U.S. Fed has bought ~$1.5 trillion worth of USTs but the U.S. Treasury has only issued ~$0.5 trillion worth of new securities, creating a massive $1 trillion worth of net liquidity and capital that needed to be rehoused.
What makes the current environment interesting from a macro liquidity perspective however, is the fact that the Fed’s has been moderating its bond buying programs rapidly, with the pace of purchases down from the March peak of $75bn per day to ~$5bn per day now.
U.S. Federal Reserve Bond Buying Has Been Moderating
Source: Bloomberg
However, given the massive U.S. deficit plus the COVID-19 stimulus programs instituted by the government, issuance of USTs is set to explode with the Treasury signalling it expects to issue ~$2.2 trillion worth of USTs over the coming ~4 months (by the end of Q3 2020), on top of the $1.5 trillion it has already issued (~$3.7 trillion in Q2 and Q3 2020).
Treasury Issuance Is Poised to Eclipse Fed Purchases (US$ billions)
Source: SIFMA, Datastream, Bernstein
Given the current run-rate of Fed purchases, only ~$0.6 trillion of the ~$2.2 trillion worth of issuance would be “covered” by the Fed, with investors needing to plug the ~$1.6 trillion gap. This would mean previously sold USTs which were warehoused in equities, commodities, etc will likely need to be reversed and put back into USTs, as the aggregate pool of capital allocated to risk assets is sharply reduced and liquidity removed from the system. While we have never witnessed a draining of this magnitude, the closest comparison would be during 2008/2009, at the the very peak of the financial crisis.
Approaching a Macro Liquidity Drain? (Treasury Issuance minus Fed Purchases)(US$ billions)
Source: SIFMA, Datastream, Bernstein
Of course the Fed may choose to sharply re-accelerate UST purchases again to cover the gap with Treasury issuance. This of course would be an incremental step towards the world of “Modern Monetary Theory” (MMT) and potentially on a path towards destabilizing the U.S. dollar as the global reserve currency with massive debasement consequences, but that is a conversation for another time.
For those that are interested however, Andrew Macken, Montaka Global’s Chief Investment Officer, actually explored the concept of MMT nearly two years ago, in this blog titled “The emergence of a new economic idea“. In it he concluded that “the concepts of MMT are interesting. We are not yet convinced that government indebtedness is entirely irrelevant. But the extreme intellectual flexibility we seek to foster in our research team leads us to have an open mind that perhaps we do not fully understand the consequences of government debt like we thought we did”. For better or worse, it seems we are on a path to test this hypothesis!
Amit Nath is a Senior Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.
