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Inflation, Market volatility and why you should be adding Secured finance liquidity.



Inflationary pressures continue and official inflation rates appear to mask the real cost of goods and services to the householder, real-world inflation could be significantly higher than official prints.


Central Banks are responding aggressively to try and bring this back under control using interest rate hikes and the scaling back of QE (QTightening).


General wisdom dictates that this inflation episode is a result of external, imported price pressure – the war in Ukraine predominantly has had a knock-on effect to energy, goods and food prices.


In reality, excess QE, post the need for it, goes some way to explain what we are experiencing now.


What do I mean by QE “post the need for it”?


The initial round of QE was a legitimate, and needed, policy response to calm financial markets as the pandemic took hold in 2019, credit spreads narrowed and liquidity increased dramatically following its implementation. However, this unprecedented and prolonged level of liquidity provision via QE, post the initial covid outset, has arguably contributed to the creation of “asset bubbles” as investors chased yield and leverage increased.


In the UK, for example, the BOE’s M4 monetary aggregate, which includes cash in circulation and the bulk of bank deposits, showed that the amount of money in the system rose at an unprecedented annual rate of 10-15 per cent in several quarters of 2020 and 2021.


The broad money supply increase, followed by a return of demand to pre-crisis levels as lockdowns lifted, saw a dramatic increase in nominal spending which, combined with some supply side shortages, was the pre-curser to current inflation levels which have been exacerbated by subsequent events in Ukraine.


Countries where monetary growth has been pursued aggressively as a covid policy response have seen some of the most dramatic and pronounced acceleration in inflation.


The catalyst for current unruly Inflation is principally the result of excessive monetary expansion in 2020 and 2021.


Risk-taking in global financial markets


Risk-taking in certain financial markets remains high relative to historical levels, notwithstanding recent market volatility. Low compensation for risk in some markets is evidence of investors’ ‘search for yield’ behaviour, which reflected the continued low interest rate environment, QE and higher risk-taking as a result.


Market participants are re-evaluating the prospects for growth inflation and this is creating vulnerabilities to sharp corrections in asset prices.


QE - From a financing market perspective


There is less high-quality collateral available in the primary market and more excess reserves (cash).


These assets are normally sourced from Banks via repo therefore driving yields on repo trades lower.


Following GFC (global financial crisis) Banks have made less balance sheet available for repo transactions as the cost of this has risen.

The excess cash means there is a need for more bonds or access to Central Bank deposit facilities – witness USD 2 trillion + currently sitting at the FED repo facility due to the lack of high-quality collateral available from Banks.


QTightening


The more dependant markets become on Central Bank stimulus to justify credit spreads and valuations, the more susceptible they are to the eventual CB withdrawal from these policies.


Should Central Banks withdraw liquidity too quickly, or the effects of such withdrawal be miscalculated, revaluation shocks potentially ensue. Rather than markets finding a new equilibrium valuation over time, these shocks can produce excessive and pronounced price movements which can lead to systematic deleveraging of positions.


VAR Shock and volatility risk.


Systematic deleveraging can happen very, very quickly. Volatility can induce VaR (Value at Risk) sensitive investors to be “forced” out of positions as stop losses are triggered, further triggering stop losses elsewhere as volatility increases due to forced position cutting. Volatility induced position cutting becomes self-reinforcing until such time that the asset value decreases to a level that VaR insensitive investors step in and begin to buy those assets. Volatility is inversely correlated to market depth. As vol. rises, market depth becomes increasingly impaired, this leads to larger price swings and consequently more volatility... bid-offer spreads widen, margin calls increase, redemptions increase and previously assumed liquidity (needed to make margin calls) in financing markets suddenly becomes harder, and significantly, more expensive to come by.


Secured financing and liquidity.


Secured market accessibility allows for market participants to raise liquidity to meet margin calls and redemptions without relinquishing ownership of the underlying asset. Acquiring cash by way of executing repo transactions requires liquidity both in terms of access to counterparties willing to accept security assets as collateral (based on collateral “quality”) and capacity of the counterparty base to do more business, (accessibility). Spreads demanded for repo market intermediation and use of balance sheet can increase unexpectedly. The repo market’s ability (and premium commanded) to satisfy customer demand for either cash or collateral can vary dramatically in line with market events and subsequent demand, balance sheet availability is a finite resource which is difficult to increase quickly.


How ConneXXion Markets help.


Secured finance accessibility - as has already been seen this year market volatility is causing many firms to pay unforeseen, and sometimes very large margin calls.

Big moves in Bond curves, SWAP’s and derivative portfolios will continue as markets adjust to increasing interest rates, volatile energy prices, currency revaluations etc – access to repo market liquidity is key to servicing unforeseen margin and collateral requirements.


Additional secured finance liquidity is easier and cheaper to access than you might imagine.

ConneXXion Markets provides market participants with alternative and cheaper, additional secured finance access from non-traditional channels. This increases our client’s liquidity pools, adding to their existing secured finance capacity, and provides them with enhanced performance - not just in times of market stress.


ConneXXionmarkets.com


The views and opinions expressed herein are those of the author and do not necessarily reflect the official position of ConneXXion Markets. They are based upon information the author considers reliable, but should not be taken as investment advice and ConneXXion markets does not warrant the completeness or accuracy of any statements made herein.



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