The Tide of Liquidity is Going Out
Weekly Investment Update | By Brian Schreiner
For years, asset markets have been surfing a wave of liquidity. Unleashed by ZERP, the Federal Reserve’s Zero Percent Interest Rate Policy (2009-2015, 2020-2022), and fueled by central bank balance sheet expansion and government deficit spending, the rising tide of liquidity has been the primary driver of the “everything bubble.”
According to Michael Howell of CrossBorder Capital the tide of liquidity is beginning to go out. In two recent interviews, one with Anthony Fatseas of WTFinance and another with Jack Farley of Monetary Matters, Howell says warning signs are appearing in the institutional overnight lending markets. Global liquidity is starting to decline, just as a massive wall of debt needs to be refinanced and current Fed policy is making it worse.
Howell is CEO of CrossBorder Capital, a London-based, independent research and investment company that he founded in 1996. Previously he was Head of Research for Baring Securities and Research Director of Salomon Brothers, Inc. The liquidity methodology he pioneered monitors cross-border flows and Central Bank behaviour across some 80 countries world-wide.
Since the beginning of the current bull market, U.S. economic growth has been modest. According to Howell, liquidity (not economic growth) is the primary driver of stock prices. "Fed liquidity is falling and that’s a danger sign," Howell said, which could mark a critical inflection point. "Everything here tells me that next year won't be a great year for financial assets. I hope I'm proved wrong, but that's what the data is telling us."
The Canary in the Coal Mine
Howell, known as the “Godfather of Liquidity,” gathers data from financial systems across the globe to track global liquidity. His model sorts the Fed's balance sheet into items that create liquidity versus those that don't.
Despite reducing the size of the Fed’s balance sheet over the last few years, Howell shows how liquidity was actually rising significantly during that time, primarily due to the Fed's Reverse Repo facility (RRP). "A rising tide of liquidity floats many boats," he says. The problem is that this is no longer happening. The RRP is nearly empty, and the Fed is genuinely taking liquidity out of the system.
Tension in the repo market is concerning because it’s essential plumbing for the U.S. financial system. Short-term, collateralized loans, known as repurchase agreements (repos) allow financial institutions to borrow cash by selling securities with an agreement to buy them back later at a slightly higher price. This market is crucial for daily liquidity and money management, allowing institutions to finance short-term needs or earn a small return on cash, while often using government securities as collateral.
The cost of borrowing in the repo market is known as SOFR (Secured Overnight Financing Rate); it’s the benchmark interest rate that replaced LIBOR (London Interbank Offered Rate) in 2022. Howell’s work shows the SOFR spread (the difference between the interest rate in the repo market and the Fed's policy rate) is elevated. The pattern (see chart below) is concerning and "The Federal Reserve seems to be pretty clear that they're not going to do this [provide liquidity] unless there is a major crisis," Howell notes. "That's not a particularly comfortable world to be sitting in right now."
The Paradox of Modern Finance
The lessons we learned in college about how savings and fund raising are the foundations for new investment may have been true 40 or 50 years ago, but that’s not how it works today.
The modern system is a debt refinancing machine. "We've got such an enormous pile of debt in the world economy that it has to be refinanced on average every four to five years. And that requires balance sheet capacity. In other words, liquidity,” Howell says.
This is the central paradox of modern finance. Debt needs liquidity for refinancing, and liquidity needs debt as collateral. But when there’s too much liquidity for the debt, you get asset bubbles; and when there’s not enough liquidity to roll over the debt, you get a financial crisis.
The debt-to-liquidity ratio is now moving strongly higher and the enormous wall of debt that was refinanced at near zero-percent interest rates is coming due. This debt must be refinanced in a system where the Fed is actively removing the liquidity needed to do so.
Investment Considerations
The rising debt to liquidity ratio is a problem for financial assets, not necessarily the real economy. Fed liquidity primarily impacts Wall Street and financial asset prices while private sector liquidity (capital expenditures, consumer spending, etc.) impacts Main Street.
Howell's data shows that private sector liquidity is actually strengthening, which could lead to a surprisingly resilient real economy in 2026, even as the stock market flatlines or experiences elevated volatility.
In financial markets, there are no unconnected events and, as Warren Buffett famously said, “Only when the tide goes out do you discover who's been swimming naked.” Risks to the everything bubble are piling up. While liquidity may not be declining in absolute terms yet, its growth is slowing.
At Alpha Rock, we are avoiding the technology and financials sectors, which thrive on liquidity, in favor of more defensive sectors such as utilities and commodities and sectors that may act as a hedge against monetary inflation such as gold and bitcoin.
Another asset class that may perform well in an environment where the global debt-to-liquidity ratio is rising is emerging and frontier market bonds. Sovereign debit tends to perform well during periods of stock market turbulence. Emerging and developing economies represent about 85% the world's population and 60% of global economic output and offer the potential for higher yield, low correlation to traditional assets, exposure to the world’s fastest growing economies and diversification from dollar-denominated assets.
If you’d like to learn more about how we’re invested and why, download our Q4 Investment Outlook. α
Interesting things I came across this week…
The U.S. is Building its Own Rare Earths Supply Chain (WSJ)
The Fed needs a strategic view, says Mohamed El-Erian (CNBC)
Hyperscalers Spending a Record High on CapEx (Apollo)
AI Is the Bubble to Burst Them All (Wired)
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