In a recent podcast, we had the privilege of gaining valuable insights from Michael Howel, renowned expert in tracking global liquidity. Michael Howel has repeatedly emphasized how we are now living in a world that is more of a refinancing mechanism; and the collateral needed to facilitate the refinancing becomes increasingly important.
Term Structure: The term structure is essentially represented by the yield curve. It depicts the relationship between bond yields and their respective maturities. One of the main determinants of liquidity is the term structure of the bond market. When the yield curve steepens, liquidity is entering the system. When the yield curve flattens, liquidity is exiting the system.
Volatility: Since bonds are used as collateral for liquidity, high volatility will decrease the “collateral factor” of bonds. Hence, the volatility of the the bond market (tracked by the MOVE index) is also a key determinant of liquidity. High volatility reduces liquidity, and low volatility increases liquidity.
Thus, Liquidity can be broken down into two components: Firstly, the amount of collateral injected into the system by central banks, and secondly, the volatility associated with that collateral.
Collateral Liquidity = Collateral Amount * Collateral Factor
Collateral in this case are bonds.
Collateral Liquidity = Collateral Amount * Collateral Factor.
The government sector controls the Collateral Amount, but the private sector determines the collateral factors (MOVE index).
Liquidity: A Weapon
Finally, Michael Howel highlights the inherent contradiction in utilizing capital markets both as a refinancing mechanism and as a tool to combat inflation. Doing so risks coinciding with periods of crucial refinancing needs and reduced capital investments, potentially leading to adverse consequences.
“In a world where the capital markets are used as a refinancing mechanism, you cannot also use the capital markets as an axe to quell inflation. Or it may coincide at a time when refinancing is in need and capital investments are down.”
Michael Howel