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Weekly Commentary

Is “Short and Shallow” The New “Transitory”?

November 18, 2022

Jimmy Jean,
Vice-President, Chief Economist and Strategist

The forecasting community is split between those expecting a recession and those believing it can be narrowly avoided. But there is a broad consensus around the idea that the slowdown should be relatively mild and short lived. The relevant question is: what’s the risk to this view?

The track record of recessions clearly identifies financial instability as among the most potent factors that could drive a more severe recession, either in terms of the magnitude of the economic contraction, the timing of the bottom or the strength of the recovery period. As a result, markets have been watching closely for any potential “signs of cracks” in the financial system.

True, global financial market infrastructure has been significantly reinforced with macroprudential measures in the wake of the Global Financial Crisis. These have included countercyclical capital buffers for large banks to ensure their resilience to shocks. Stress-testing mortgage borrowers for their ability to withstand higher rates is another example and is proving particularly prescient right now. Higher mortgage rates are a headache for many variable-rate borrowers in Canada. But let’s imagine what would be happening now if more fragile borrowers had been granted mortgages.

The macroprudential measures put in place are not without limitations, however. Smaller balance sheets kept by capital market dealers is the direct result of the more stringent capital and liquidity requirements associated with rules implemented in the middle of the last decade. US Treasury Secretary Janet Yellen recently voiced her concern over the lack of liquidity in the Treasury market, with dealer balance sheets having failed to track the growth in the supply of government bonds.

Until this year, quantitative easing (QE) was helping mitigate those tensions as the Fed absorbed a significant chunk of the supply. It’s rather the opposite in the quantitative tightening world we’re in today. Various measures of market functioning in the US Treasury market have been sending warning signals. For instance, the volume of Treasuries that primary dealers agree to trade at prevailing bid and ask prices, an indicator of market depth, has been hovering near record lows all year for shorter-dated bonds.

The growth in the size of open-ended investment mutual funds is another area of concern. These funds provide their shareholders with the right to redeem their shares on demand, although some of them are invested in assets that can be illiquid. If for whatever reason redemptions surged, funds would need to liquidate assets to repay investors. This could both depress the value of the assets held by given fund and reduce the value of the assets of other funds. That would in turn give investors an incentive to liquidate their shares across the sector.

A feedback loop is then created, as funds need to sell even more assets. The more illiquid the assets, the bigger the impact on prices. This isn’t just a theoretical risk. Mismatches between the liquidity profile of these funds’ assets and that of their liabilities contributed to the market turmoil of March 2020. In that episode, the hemorrhage was ultimately stemmed only when the Fed and other central banks extended their asset purchases to include corporate bonds.

It was an easy call to make back then since the improvement of market functioning was aligned with monetary policy objectives to support economic activity. Today, central banks are dealing with one of the most difficult monetary policy challenges they’ve faced in decades. As a result, central banks are wary of using rates and balance sheet policies for cross purposes. That constraint means there’s a higher risk of very sudden market moves, with the potential to trigger vicious cycles. Some solutions have been proposed, including broadening access to the Fed’s liquidity facilities to market participants beyond primary dealers and expanding central clearing.  But we don’t know whether they will have been implemented before something very bad happens.

Few central bankers seem interested in elaborating on these issues. The Bank of Canada (BoC) did say it was trying to balance the risks of under and over tightening. But the BoC is mostly concerned with domestic debt-related risks. And the BoC isn’t the one overseeing functioning in the world’s most important bond market. Still, at the beginning of this month, Fed Chair Jerome Powell kept stressing how the Fed didn’t want to run the risk of failing to tighten enough. Fed Governor Lael Brainard is among those who have discussed the issue most frequently. She noted in October how “a sharp decrease in risk sentiment or other risk event that may be difficult to anticipate could be amplified, especially given fragile liquidity in core financial markets”.

In contrast to most central bankers’ rhetoric, various financial stability reports—such as the one from the IMF and the one from the Fed—are sounding preoccupied. Central bankers will probably continue to talk tough on inflation in the very near term but the limits on how far they can go are starting to show. This suggests that they are unlikely to ignore ever-louder warnings for very long. Remember that this is largely about tightening financial conditions. The ability to do so in a controlled fashion diminishes the higher rates get and the more dealers need to contend with an amount of supply they don’t have the capacity to handle. It also diminishes as the cumulative effect of concerted tightening policies globally causes some sudden and unforeseen liquidations in some investment vehicles.

In short, central banks could cause some significant damage in their quest to break inflation. So far, these tensions—including those in the cryptocurrency space or in emerging markets—have not provoked a “Lehman-moment” but thinking about these risks in a linear fashion might be a mistake. When we get asked how our mild recession scenario could turn out to be a severe one, a negative financial system event comes to mind. Such an event would be the result of central bankers overestimating the financial system’s tolerance to tightening, and this possible miscalculation is one of the dominant risks to our outlook.

And even if the system doesn’t break, mistakes could still be made if central banks push tightening beyond certain tipping points. Here in Canada, there are many reasons to believe the economy to be particularly vulnerable if the Bank of Canada acts too zealously. We will look at what that could mean in an upcoming Economic Viewpoint. But the broader point is that whether the “short and shallow” theme ends the same way “transitory” did is really going to be up to monetary policymakers.

Read the full commentary: Is “Short and Shallow” The New “Transitory”?