Market returns & liquidity-Financial Markets Post Covid

A lot has changed in the capital markets , since the covid era , although nothing new if you look at the history . We humans have the habit of repeating mistakes and below are events that have transpired , one of the ways to understand them is through market liquidity.

So, Liquidity is  combination of economic overview and how the fed/central banks   responds to economic situation . Just look at the combination of the chart below, the index on the top is global money supply and on the bottom is the S&P 500 index , I can replace it  with global equity markets also , it’s almost exactly the same. Before 2012 there was no such correlation , after 2013 this correlation has become much more stronger. The correlation is almost .91 . The Liquidity precedes the markets.

Liquidity & S&P 500 IndexLiquidity & S&P 500 Index

This is how central bankers have made us richer, had it not been for liquidity, markets wouldn’t have gone up . Now they want to take away the wealth , see the white line( Upper graph)  , they are reducing money supply in the market. Bitcoin is the red, commodities markets are in red , people are thronging towards fixed income instruments( smarter ones) , which is also leading to inversing of the yield curve.

Forex Liquidity :

If the forex goes down , the world equity markets will suffer and vice versa. Right now , Liquidity is leaving the banking  system ,thereby  the cost of capital goes up & the cost of speculation also goes up too.We had 10 lac cr liquidity in banking in India , we have almost zero in our banking system .I am sure everyone must have got calls from their banks, asking to start a new FD ,because the rates have shot  up to 7% .

Money Supply Globally

In  last few weeks , we have added 6 lac cr of forex reserve though. In the figure on the right , the liquidity is at the lowest level since 2008. The damage you are already  seeing around the world markets , its humongous in global assets, FAANG was valued at 11 trillion dollars in Nov, 2021, Today its 5.7 trillion dollars. The bitcoin and dogecoins were at their peaks in month of July in 2021.

Who shrunk the liquidity in the global markets ?

If you look at the graph  on the right , it shows the forward rates, 1y1y , one year rates one year from now – the expected inflation rates ( one year )  one year from now ( 1y1y) .

Just look , since the time Jerome Powell has been the Chair  of Federal reserve(2018) , the graph has been going down. The real value of money was less than zero , its only now or after late 2021 , the graph has been starting to go up. It is now on the 100 bps zone , very tight in nature. This  time was ideal for money making , the TIPS bonds  ( Treasury inflation protection securities ) bonds, were giving less than zero in coupon rates, now they are giving coupon rates are at inflation Plus some spread on that , first time in the last 9 years.

Central banks Are Angry :

We are currently ,in  the worst tightening of the century . If we look at the recent data of the rate hikes of the Federal Bank , it will tell you that feds are at it this time. It feels like someone girl dumped a guy and he made the rest of the world pay by increasing fed rates , Jokes apart this looks scary .

Just look at the graph , the hike in this cycle is the steepest in past few years. This steepest hike is breaking central banks across the globe. The central banks in the past 2-3 years bought bonds at one percent yield or two percent yield , in Europe they bought it at negative yields. Now, the interest rates are rising again , these central bankers are now getting bankrupt. Why ?

Because these securities are were tradable securities bought for short terms , in the accounting standards these securities are always marked to market ( MTM) , Because of the hikes in the rates the P&L of the central banks are all in RED.

So, can the central banks keep on raising these rates,? NO, because  ,they are holding these bonds, and the interest rates are burning  holes in  their pockets.

What happens when the liquidity shrinks ?

A dog walking start-up raised 200 million dollars two years back , if you knew how to make power point presentations you could have raised millions in last few years. But where are those billionaires now ?

If you see the graph , it shows two volatility indicators. VIX is for equity and Move is bonds today ,Microsoft 10 year bond is there for 10 % yield in Dollars btw, and people still want to buy equities .The risk premium is too high to buy equities but still the liquidity is high there, the markets.  The bond volatility was going through the roof, the system . IF you look at  bond markets investment grade bonds in dollars are there at 7-8% yield , but still people will continue to speculate . The History will repeat ,like it has for several decades.

Sequoia capital -one of the smartest guys when it comes to investing  divested their assets on the right time and are doing fine ,in comparison , Tiger global are down 60% today , they are not funding any start-ups today.

Consider start-up is 100 year bond , , which has a coupon rate of 2% , its trading at 2X par value of 100. You can replace this 100 year bond with any start-up with no cash flows , Every start up was like that , when the interest rates were down  the valuation kept on  going up . So , now that bond is trading at 50 Rs , just like a start-up . This is a magic of duration ( measure of risk in bonds ) .

When the interest are zero you can have any PE ratio, when the same interest starts going up the PE starts contracting .So , going forward all the start-ups which were built on low interest rates, will find it harder to raise money , and the ESOPs ( stock options ) given to employees will lose value.  This all, what I have talked about has happened in the past too , these mistakes were done in the past too , and THEY will keep happening again.

Written By: Ankur Kushwaha, Sr. Consultant, Invest Punjab | Govt. of Punjab.

DISCLAIMER: Views expressed are personal.

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