Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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This chart tell us more about what is happening in financial markets than any other
Christopher Dembik
Head of Macroeconomic Research
Summary: There is one thing that really matters more than others, and it is global U.S. dollar liquidity. The bad news is that it is in contraction for the first time since early 2019. Usually, this is a synonym of market turmoil and higher risk aversion. We consider this is certainly one of the most important and less mentioned drivers behind the continued drop in financial markets in recent months.
This is a fact : we operate in a dollar-based world. Therefore, U.S. dollar liquidity serves as a key driver of the global economy and financial markets. At Saxo Bank, the evolution of U.S. dollar money supply is our favorite dollar liquidity indicator. In the below chart, we track U.S. dollar liquidity based on the evolution of the monetary aggregate M2 in the twenty-five largest economies converted into U.S. dollar and minus the evolution of M3 in the United States. This is certainly the most important chart to understand what is currently happening in financial markets.
In the wake of the outbreak, U.S. dollar liquidity increased reflecting efforts from the U.S. Federal Reserve and other major central banks to avoid a liquidity crisis similar or worse than that of 2007-08. It was successful. Since mid-2021, U.S. dollar liquidity has slowly started to decrease. But liquidity remained abundant until very recently. The liquidity issue on the UK bond market, which triggered an emergency intervention from the Bank of England, is one example of what may happen in the coming months if liquidity, especially U.S. dollar liquidity, is scarce. The two last times financial markets went through such a contraction in liquidity, it was in 2015 (when China devalued the CNY) and in early 2019 (at that time, the focus was on the Chinese-U.S. trade war). It caused an emerging market turmoil, deteriorated financial conditions and higher U.S. dollar funding costs. But there is one major difference compared to 2015 and 2019, there was no inflation at that time. It is now the single one major issue for policymakers. Given inflation will remain volatile in the months to come and that it has not peaked in most countries (with the exception of the United States), central banks have no other choice but to keep normalizing monetary policy. This means that U.S. dollar liquidity will continue to fall in the short-term. It will have a net negative impact on financial markets, especially the equity segment, and the global economy (for more on our Q3 earnings expectations, see Peter Garnry’s latest article).
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