In the US, financial institutions are still effectively parking a huge USD1.6tr at the Fed via reverse repos. 

For the moment, Mr. Steve Barrow, Head of Standard Bank G10 Strategy, leans towards the former, but things could easily change. The real nightmare for investors is when they fear that they can’t get their money back, or if the cost of doing so increases exponentially. That’s happening in Russia, and now we are looking closely to see if this infects the whole spectrum of financial assets. Of course, asset prices have fallen in sympathy with what’s happening in Ukraine and its adverse economic reverberations. But the jury is out on whether the rush to sell reflects only fears that assets held will decline in price, or whether there is the more insidious risk that the cost of maintaining such positions could escalate as liquidity dries up.

Unsurprisingly, many measures of financial stress have started to increase since the Russia-Ukraine conflict. In the US, indicators such as libor-OIS spreads, commercial paper spreads, the treasury/eurodollar (TED) spread and more have all flashed warning signs. But so far, most of these movements are far short of what we saw during the COVID crisis and even further from the levels seen in the 2008 global financial crisis (GFC). This does not mean that the pressures are modest and that they will fall short of prior extremes. It probably helps that liquidity was very high before the Russia-Ukraine conflict.

In the US, for instance, financial institutions are still effectively parking a huge USD1.6tr at the Fed via reverse repos. That’s cash the banks don’t really know what to do with. In the eurozone, the ECB’s measure of excess liquidity is around EUR4.5tr, or two and a half times its pre-Covid levels and more than twenty times its pre-GFC levels. That’s the good news. The bad news is that central banks are starting to reel in this excess liquidity as they move towards quantitative tightening.

In addition, Mr. Steve Barrow said prior central bank monetary largesse has helped contribute to a huge inflation problem, meaning that central banks can’t throw more money at the problem if liquidity really tightens up in financial markets. Of course, there are inbuilt provisions to temporarily supply liquidity, such as central bank swaps and repos from the Fed. But whether these can prove sufficient to stem investor selling given that banks are unable to cut rates and re-start QE is a question that we think deserves to be answered in the negative. So far, data from the Fed suggests that foreign central banks have not had to make greater use of the swaps and repos that are on offer, and if we look at cross-currency basis spreads, the signs here remain reasonably good.

While it is a bit early to make any definitive conclusions, it appears that, so far at least, liquidity strains are quite modest and hence not an undue cause for alarm. But things could change very quickly, if Russia were to attack countries outside Ukraine or cut off European gas supplies, for instance.

However, Mr. Steve Barrow doesn’t think these things will happen. A Russian default could still prove an event that tests these credit spreads, even if it is discounted. Hence, he would caution against taking a particularly rosy view of the liquidity situation at the moment, or at least until he sees an end to the crisis that could yield a return to a more "normal" relationship with Russia. But herein lies the rub, because this still seems a very long way off, while the economic and financial reverberations will continue to negatively impact asset prices even as relations thaw. The bottom line is that we still (just) side with the view that G10 asset prices will avoid a precipitous fall, but will still fall, nonetheless.