Welcome to Thoughts on the Market. I'm Matt Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Thursday, November 12th at 3:00 p.m. in New York.
I want to talk about liquidity because I think it’s been an important factor in macro markets this year. For example, I thought the influx of liquidity, in addition to a V-shaped global economic recovery, would weigh on the value of the U.S. dollar. And since I discussed that on this podcast at the end of April, the broad trade weighted dollar has lost about 7% of its value.
More importantly, I think liquidity will be an important factor for macro markets next year as well. Before I get into it, liquidity can mean different things to different people, so let me explain what I mean. Some people define liquidity as the ability to transact a high volume at a low transaction cost. Others define it as the ease with which you can convert an asset into cash.
While those are acceptable definitions, today I’ll talk about what I call “narrow liquidity”. This is the ability and willingness of actors in the economy to buy and sell assets via central bank reserves – what you might consider to be electronic cash.
Central banks can increase the supply of these reserves by purchasing securities in the open market. That’s what we call quantitative easing, or QE. Likewise, central banks could decrease the supply by selling securities. As you may know, in response to the economic effects of the pandemic, central banks in the G10 injected more liquidity in 2020 than ever before. We put the total at about 4 trillion dollars.
2021 is going to be another big year for liquidity, even if it won’t rival this year. On our projections, G10 central banks will inject another $2.8 trillion worth of liquidity next year. To put that into context, that will be over twice the amount of liquidity central banks injected in any year prior to this one.
Of course, this liquidity doesn't have to find its way into financial markets immediately. And even if it does get invested, it doesn’t need to be placed into risky assets like equities or high yield bonds. In fact, ahead of the U.S. election, we saw over a trillion dollars of this newfound liquidity find its way into money market funds. This brought the total assets under management in those funds to $5 trillion.
Now that the U.S. election has past, and a certain amount of uncertainty around its outcome has diminished, some of that frozen liquidity is starting to thaw. Naturally, other sources of uncertainty still remain: how the flu season will coincide with the second wave of COVID-19, the timing of vaccine distribution, the end of lockdowns in Europe, and possibly a return of them in the U.S.?
All these uncertainties, what some investors call “walls of worry,” will prevent all of the pent up liquidity from flowing in the immediate future. But, as each of these uncertainties fade in 2021, investors will feel more comfortable putting that cash to work and taking risk - especially if the global economic backdrop remains as robust as our economists are projecting.
As a result, we retain a risk-on bias in our investment recommendations, and we see this liquidity affecting rates and currencies alike. We see Treasury yields rising next year, but more modestly than many investors might like. We see the 10y Treasury yield ending 2021 below 1.5%. But, the good news is, the Treasury curve should steepen.
We also think the U.S. dollar has further to fall against a host of G10 and EM currencies next year. In the end, the amount of U.S. dollar liquidity will be so great that we think it will overflow U.S. borders – just as long as uncertainty falls next year from its extraordinarily high levels this year.
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