Once again a misconception is gaining currency. There is increased talk of a build up of cash just waiting to be converted into equities or other assets. I wrote about this years ago in cash on the sidelines, but apparently the financial commentariat did not read the post, so it is time to revisit the subject.
I believe that the reason the misconception is so widespread is that the subject is not discussed in technical terms, but in metaphors. Some of you have heard the phrase “the great rotation”, which refers to the idea that investors will shift en masse from cash and bonds to shares. It’s a compelling phrase, but it leaves one question unanswered: who will sell the shares to these rotating investors and, given that these sellers will be paid for their shares, what happens to the money they receive? It’s still cash after all. Likewise, if these rotators are selling their bonds, someone has to buy them. Post-rotation, there is still just as much cash in the system and just as many bonds. Cash and bonds don’t just magically turn into shares. Reality is messy…why spoil a good metaphor?
A simpler, more dramatic and more vacuous metaphor that has also made a reappearance is the “wall of liquidity”.
No one using this compelling phrase would be so crass as to explain what it means. Such is its power, it is assumed that we all know what it means. So, let’s have a look at “wall of liquidity” out in the wild. In an article about rising bank share prices, Michael Bennet wrote in The Australian:
But pump-priming by global central banks has created a so-called wall of liquidity looking for income that is flowing out of cash and into high-dividend-paying stocks, with banks attractive due to their fully franked dividends.
Here it certainly sounds as though “wall of liquidity” is just “cash on the sidelines” in a fancy suit. But let’s zero in for a moment on the other metaphor in this sentence, “pump-priming”. Doubtless, the author has the US Federal Reserve (Fed) in mind. The standard line runs something like this: with low interest rates and purchases of securities through the “QE” (quantitative easing) programs, the Fed has flooded the banks with liquidity. More prosaically, reserve balances (i.e. the accounts banks have with the Fed) have grown. So far so good, as the chart below shows.
The next step in this line of thinking is that as this cash builds, it is a “wall of liquidity” desperate to find somewhere to go and, in the quest for investments, it will push up asset prices.
But before we can accept this reasoning, there is an important point to note. Reserves with the Fed are assets of banks only. Contrary to a common misconception, these reserves cannot be lent, they can only be shuffled around from bank to bank. Nevertheless, there is a theory that, because in the US and some other countries, a certain percentage of bank deposits must be backed by reserve balances, there is a “money multiplier” which determines a fixed relationship between reserve balances and bank deposits*. If this theory is correct, bank deposits should have grown as dramatically as reserve balances. They have not.
Taking the same chart and displaying it on a log scale shows that growth in deposit balances has been very steady over the last 20 years.
Whatever is going on in financial markets, it has nothing to do with a dramatic build up of cash which is poised to be converted into “risk assets”.
Yet another way to see this is to think about what is going on in Australian banks at the moment. Credit growth is slow in Australia. This is not because banks are reluctant to lend. Quite the contrary. Banks are looking at the slow credit growth and fretting about their ability to deliver the earnings growth that their shareholders have come to expect. The problem is that there is a lack of demand for credit as households and businesses continue to save and pay down debts. In response, banks have begun to compete aggressively on price and, in some cases, on terms to attempt to grow the size of their slice of a pie that is not growing. And yet these very same banks continue to compete for customer deposits. Australian banks are not sitting on vast cash reserves that are compelling them to lend. Rather it is simply renewed risk appetite that is driving banks to compete for lending.
The same is true around the world. Looking at cash balances as a sign that yields will fall and asset prices will rise is a pointless exercise. What is happening is much simpler. Animal spirits are emerging once more. Low interest rates (not cash balances) will help, but fundamentally it is risk appetite that drives markets.
The last time I heard people talking in terms of walls of liquidity was in 2005-2006 in the lead-up to the global financial crisis. These putative piles of cash were used to support a change of paradigm in which the returns for risk could stay low indefinitely. Of course this turned out to be dramatically wrong. The cash didn’t disappear, but risk appetite did. I am not predicting another crash yet, but I do foresee this nonsense being used to justify more risk-taking for lower returns. If that happens for long enough, then there will be another crash.
* As an aside, given that Australia has no minimum reserve requirements, if the money multiplier theory was valid, there should be an infinite amount of deposits in the Australian banking system. For the record, this is not the case.
Photo credit: AP