RBA: Liquidity, here today but tomorrow?
The latest speech by the Governor of the Reserve Bank of Australia (RBA) is well worth a read. RBA speeches typically provide greater insights of issues considered by the Board, and it seems that the Bank is becoming increasingly concerned with the state of global financial markets.
One particular theme we note from the recent speech is the RBA’s concern with potential liquidity constraints in world markets. Liquidity relates to the ease an investor can enter and exit a position without impacting the price. With so much capital moving around global markets, fuelled by the ongoing supply of cheap credit by major central banks, you would think that liquidity is a less pressing concern than elevated asset prices.
But perhaps because this capital needs to find a home, custodians of those funds are being forced into lower-quality assets and asset classes. The danger the RBA is focusing on here is not the quality of the investment, but the perception that liquidity is comparable to the higher-quality assets, which is perhaps just a construct of the current easing environment. It is only when financial markets are stressed that investors truly understand the real liquidity of their holdings.
The RBA fears that the risk of a sell-off could be “abrupt” in lower quality asset classes. The relevant excerpt from the speech is provided below (our emphasis added):
The other factor of importance is a set of structural changes in capital markets, where there are two key features worth noting. One is the expanding role of asset managers. The search for yield, and the general tendency since the crisis for some intermediation activity to migrate to the non-bank sector, has resulted in large inflows to asset managers since the crisis.
Yet liquidity – the ability to shift significant quantities of assets in a short period without large price movements – has probably declined, which is the second of the structural changes worth noting. Certainly the willingness of banks and others to act as market-makers in the way they did in the past will have diminished considerably. Now, of course, to some extent this is a result of the changes to financial regulation which have aimed to improve the robustness of the financial system. We should be clear that it was intended that the cost of liquidity provision in markets be more fully borne by investors. Liquidity was under-priced prior to the crisis.
Nonetheless, the question is whether end-investors truly appreciate that the availability of liquidity in the system has declined. Good asset managers have sufficient liquidity holdings to meet redemptions that may occur over any short time period and will also offer appropriate redemption terms and so pose only limited risks to the broader financial system. But the cost of holding the most liquid assets in a world of very low returns overall may pressure some asset managers to hold less genuine liquidity than they might otherwise. Meanwhile, the amount of client funds being managed is much larger than it was and we don’t know how all those investors will behave in a more stressed environment, should one eventuate. A key concern the official sector has is that investors may be assuming a degree of liquidity that will not actually be available in a more stressed situation.
Putting all that together, we find a world where the banking system is much safer, but in capital markets some valuations are stretched, credit spreads are compressed, there has been significant cross-border capital flow and liquidity may be less available than investors are assuming. That raises the risk that a sell-off, were it to occur, could be abrupt.
While the RBA considers appropriate policies to address this issue, Montgomery Investment Management will remain resolute in our core philosophy to invest in high quality companies with bright prospects at attractive prices.
Ben MacNevin is an Analyst with Montgomery Investment Management. To invest with Montgomery, find out more.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Michael Shapiro
:
Thank you for the interesting discussion point Ben. I wonder what exactly RBA is considering to mitigate the issue. What RBA seems to be lamenting, is the fact that lower cost of capital created conditions where funds had flowed to higher yielding but more risky assets. RBA seems to be warning investors that should conditions change, those lower risk assets will experience a sell off. However, RBA can directly cause the sell off, by increasing the cost of capital. They can also prevent the sell off by keeping the cost of capital low.The only situation RBA would be issuing this warning, is when they would be considering increasing the cost of capital, and thus nudging market participants to scale back their risky bets…However, if they are not planning any interest rate increases, then this speach is nothing more than just pondering the hypotheticals.
Roger Montgomery
:
They’re quite stuck Michael…
Adrian Totols
:
Dear Ben,
I note your comments differ from Treasurer Hockey’s comments currently airing at Australian Israeli charter of commerce today.
I note the Greeks are scraping the bottom of the barrel at the bottom of the Europe with $2.0 billion euros in the bank, with $1.7billion euros of pension payments and government payments liabilities in the next week. There are reports that the Greek Government is asking local councils for cash in their tills. Beware of Greeks bearing 10 year bonds are yielding 13.25%, the contagion needs to be stopped. I note the comments in the RBA statement that a ‘run on poor quality investments’ held by fund managers in their attempt to find other forms of yield than the banks. There is a possibility seen several years ago in Cyprus of a run on the investments.
Roger Montgomery
:
As an analyst Adrian, you should measure three times and cut once. The reference to blood on the streets and market its knees was a reference to the ideal time to buy and the inevitability of such a period in the future. Just as the market has had periods of exuberance in the past followed by periods of depression and despondency, so it will be repeated in the future.
Brodie Nicholson
:
Very interesting Ben!