The abrupt liquidity crisis that befell some UK pension plans this week and forced the Bank of England’s intervention may be a harbinger of things to come, according to Ruffer’s chief investment officer Henry Maxey.
The posh UK investment manager became briefly known as “50 Cent” due to its idiosyncratic Vix trading pattern, and showed its contrarian stripes with a $600mn bet on bitcoin in 2020.
Maxey doesn’t explicitly mention the recent gilt-market calamity in an internal memo FT Alphaville got its hands on — it seems to have been written earlier in September — but after the recent mayhem it’s hard not to read it with that in mind, given the memo’s dominant theme.
Echoing the mantra of Goldman Sachs’s now-departed head of global market research Charlie Himmelberg, Maxey argues that “liquidity is the new leverage”, and frets that accidents lie ahead of us.
So far this year, we have seen a repricing of risky assets. Now, we see the potential for something worse: a growing pressure for the liquidation of risky assets. Higher short term interest rates mean that people now own too many risky assets.
I believe they may not be able to liquidate without having a material impact on the asset price. Or won’t be able to liquidate at all — think private assets. Anticipating when this vulnerability might be exposed requires a view on the drivers of a liquidation. I would highlight three key drivers:
1, Liquidity: the stock and flow of the system’s aggregate financial balance sheet, ie the central bank and the commercial banks’ combined balance sheet. How big is it relative to requirements and is it growing or shrinking? Who will expand their balance sheet to accommodate the risky assets?
2. Real yields: are they rising? And how fast? We have a range of indicators along the curve which we monitor
3. Lagging six month performance: is it poor relative to recent history and expectations?
The memo focuses mostly on the first of these aspects. In other words, on the seismic withdrawal of central bank liquidity, and how that might interact with the financial system slowly but then suddenly.
Maxey’s view is that the underlying conditions for a “liquidity crisis” has been present for a long time, but the combination of interest-rate increases and quantitative tightening programmes by central banks led by the Federal Reserve means that a burst of liquidation can happen at any time.
My argument is that it is not just the size of balance sheets that matters, their composition does too. And, right now, composition matters more than size. The shift in the composition of the Fed’s balance sheet from bank reserves to RRP liabilities drains liquidity from a broad risk taking banking system to a very narrow risk taking one.
The shift in composition of commercial bank balance sheets from financial circulation to industrial circulation in order to support a larger nominal economy reduces the liquidity available to financial markets. And regulatory pressure impedes their ability to expand risk taking. Suddenly, the idea of excess liquidity in the system starts to look very tenuous, particularly from a financial market perspective.
. . With trailing performance already poor — a good predictor of outflows — and real interest rates potentially heading higher still, the conditions for a major liquidation crisis are in place.
Maxey thinks that an investor “stampede” into private markets exacerbates the dangers. And it’s hard not to agree.
Over the past decade, low bond yields have pushed many insurers, pension plans, sovereign wealth funds and endowments into private equity, venture capital, real estate and infrastructure — areas that promise higher returns if investors lock up capital for multiple years at a time.
Of course, the danger is that if investors suddenly need to raise cash — say, because they unexpectedly have to meet margin calls after a once-a-century bond puke — then all the onus will fall on the remaining public equity and bond parts of their investment holdings.
As Maxey says:
This means that de-risking will very likely be forced through the liquid part of portfolios, exacerbating the volatility of moves in more liquid markets. I anticipate we will have funds gated and a cascading of liquidity demands through from what investors want to sell to what they can sell. In the end, this is likely to result in the sale of mega-cap US equities and, ultimately, the US dollar.
Because of this, Maxey said that Ruffer was “extremely cautious”. At the time of the memo the UK investment manager was taking the lowest amount of risk of any time since Maxey first joined in 1998.
The memo opens up with a quote from La Haine, a mesmerising 1995 French cult film, detailing how a man falling from a 50-story building repeats to himself “so far so good”, with the pay-off being “the important thing is not the fall. It’s the landing”. The ending of Maxey’s note riffs off this:
The Fed wants a soft landing.
But it has to beat inflation.
Interest rates are rising fast.
We’ve seen steadily falling asset prices but no panic and no material outflows from US equities.
So far, so good . . . “Jusqu’ici tout va bien . . . Jusqu’ici tout va bien . . . Jusqu’ici tout va bien.”
But the important thing is not the anticipation of rising interest rates, as reflected in falling bond prices. It is the landing of the Fed’s interest rate rises on the liquidity of a hyperfinancialised system.
But the important thing is not the fall. It’s the landing.
