2024 will likely mark the end of a period of extraordinary liquidity. We address five questions whose outcomes could have material effects on the liquidity and volatility of global credit markets.

1 – Can The Fed Land The Monetary Policy Plane?

On the one hand, the Fed plans to cut rates, which, all things equal, should loosen financing conditions. On the other, it intends to rein in its past largesse by persisting with quantitative tightening (QT). This will require a balancing act.

Markets are convinced that rate cuts are just around the corner but the exact timing and amount of these cuts remain uncertain.   The Fed's current stance can be best described as "wait and see." If necessary, room for further hikes exists but rate cuts have become increasingly likely (see chart 1). The Fed is sensitive to the risks that come with remaining restrictive for too long--thus causing unnecessary economic pain--and easing too soon, thereby risking a resurgence in inflation. Tellingly, Fed chairman Jerome Powell suggested during a press conference in December 2023 that the Fed must reduce the policy restriction on the U.S. economy before inflation reaches 2%. If the Fed holds back cutting rates until the 2% inflation target is reached, the fear is that the U.S. economy could suffer because of the monetary policy's lag effect. Cutting rates sooner rather than later would also be in line with the Fed's intention to stop undershooting the inflation target.

Chart 1

The Fed's QT course seems to be on autopilot for now.   The Fed continues with the roll-off of Treasury securities, capped at $60 billion per month, and mortgage-backed securities, capped at $35 billion per month. The Fed has already shed more than $1.3 trillion in assets since the start of QT in June 2022 (see chart 2). The questions are, how long will the Fed continue with its balance sheet reduction at the current pace--and when will it end?

Chart 2

The bond market is watching.  Based on real and perceived monetary policy nuances, the bond market tries to ascertain the monetary policy path for 2024. Market participants seem unanimous that the Fed's next action will include a rate cut but that's about all they agree on. Year-end projections are diverging considerably, which raises the risk of renewed or increased volatility if markets find themselves materially at odds with central bankers. This dissonance could lead to a reduction in market liquidity.

Market participants' expectations of monetary easing loosened tight financial conditions, whose negative effects on the U.S. economy reduced over the past few months.   If the Fed announces to slow QT over the next few months, financial conditions could loosen more than they would without the announcement. Paradoxically, and all else equal, looser financial conditions make it harder for the Fed to achieve its price stability mandate. If the Fed doesn't maintain sufficiently tight financial conditions for the time being, the risk of reversing the progress made so far on inflation rises. This suggests the Fed will likely take a more gradual approach to rate cuts than markets have priced in. 2024 is going to be tough for central bankers as markets will second-guess or try to frontrun their actions.

2 – Are European Banks Ready To Step Up?

European banks play an outsized role in financing the economy since capital markets in Europe are not as large and deep as in the U.S. As the European Central Bank (ECB) and other central banks in Europe aim to gradually drain excess liquidity from the system, we think liquidity provision by major European banks becomes increasingly important.

So far, European banks have contributed to resilient financing conditions in the European economy.   We believe the sharp drop in annual bank lending growth in the eurozone to about 0% at the end of November 2023 (see chart 3) mainly reflects central banks' monetary tightening. Banks passed on most rate increases to loan customers and therefore dampened the demand for bank loans. Overall, European banks managed interest-rate risks well and proved their financial resilience during several macroeconomic shocks. They were able to serve clients, even at higher rates, and followed a more selective approach for the most vulnerable sectors, including commercial real estate. European banks' relatively strong health was one of the reasons why they could avoid a full-blown liquidity crunch, including the potential spillover effects on economic growth and employment rates.

Chart 3

2024 will test European banks' funding and liquidity conditions, which could complicate some banks' ability to fund the economy.   European banks will need to navigate the compounding effects of multiple central bank actions that aim to drain excess liquidity from the financial system and reduce balance sheets (see chart 4). In the eurozone, these actions materialize in the form of accelerated targeted longer-term refinancing operations (TLTRO) repayments and passive QT. Yet, the ECB could announce more measures--for instance an increase in unremunerated minimum reserves, which would trap some of banks' excess liquidity--as it finalizes the review of its operational framework in the first quarter of 2024. We think such actions could have asymmetric effects on Europe's banking systems since excess reserves are not equally distributed between banks. In this tighter liquidity environment, we expect banks will compete more aggressively for the cheapest funding source, namely deposits. This competition will ultimately lead to higher funding costs for banks, some of which will be absorbed by lower margins or passed on to lending customers.

Chart 4

We see tightening funding and liquidity conditions for banks as signs of a gradual normalization and a potential source of downside risks.   High interest rates and enormous excess liquidity in the banking system have generated a temporary margin boost for banks that is bound to normalize gradually. A key question for 2024 will be whether central banks can avoid bouts of financial instability during this normalization process. We consider the banks' resilience and central banks' risk management tools, including the transmission protection instrument in the eurozone, are supporting factors. That said, we remain mindful that some risks have shifted to non-bank actors after years of low rates. Non-bank actors are less regulated, can be less transparent, and don't have direct access to central bank facilities.

3 – Will China Increase Or Reduce Global Liquidity In 2024?

Monetary policy decisions in the world's second-largest economy can influence global capital flows significantly. We believe China will likely have a positive effect on global liquidity, which reflects its accommodative monetary policy and expected net financial outflows.

Considering that economic growth and inflation will likely be modest, the People's Bank of China's (PBoC's) monetary policy will probably remain accommodative.   Even if U.S. rates decrease later this year, the PBoC will have little scope to lower its policy rate since Chinese interest rates fall significantly short of U.S. rates. We therefore expect rates will decrease only modestly in 2024. But the PBoC will ensure ample liquidity in financial markets by conducting open market operations and lowering reserve requirement ratios (RRRs) further (see chart 5). In December 2023, for example, the PBoC channeled renminbi (RMB) 350 billion through the re-deployed pledged supplementary lending facility, which aims to support China's economy by providing banks with low-cost, long-term financing. At the end of January 2024, the PBoC announced a 50 basis points cut in the RRR for banks.

Chart 5

If risks materialize, we expect the PBoC will react timely to market stress.   Several local or sector risks, including small banks' significant exposures to problematic property or local government debt, could impair the interbank market. That said, we expect the PBoC would mitigate any negative effects with liquidity injections. For example, when the interbank market was in turmoil at the start of the COVID-19 pandemic in 2020, the central bank quickly injected liquidity to restore calm.

Net financial outflows will likely persist in 2024, although at a moderate scale.   While the PBoC's monetary policy should be relatively accommodative, we expect the demand for credit will remain modest because of low investor confidence. The latter should also weigh on domestic financial investments. Additionally, we believe an increasing number of Chinese institutional investors will seek investment opportunities abroad because of potentially higher returns and interest rates (see chart 6). This trend started in 2022.

Chart 6

Net financial flows have been significant in recent years.   Based on our estimations--which stem from our macroeconomic framework for the balance of payment and include all types of financial flows, including unrecorded ones--net financial flows reached a whopping $366 billion in the difficult year 2022. However, net financial flows reduced to a more modest $21 billion in 2023.

We expect the attraction of foreign assets will remain significant even if global interest rates reduce this year.   This lure of foreign assets results from the downward pressure on interest and return rates in China. Still, capital controls and regulations will dampen many types of outflows. If financial turmoil in China increases, we expect to see a tightening of capital controls.

We expect the internationalization of the RMB will affect USD transactions only modestly.   Efforts to promote the usage of the RMB will continue. While it makes sense for certain economies and companies to expand the use of the RMB, we don't foresee that the RMB will challenge the global dominance of the USD any time soon.

4 – Will MMFs' Ability To Provide Liquidity Benefit Or Suffer From New Regulations?

MMFs on both sides of the Atlantic play an increasingly important role in liquidity provision. U.S.- and EU-domiciled MMF assets almost doubled since 2013, with reported U.S. MMF assets totaling about $6.4 trillion and EU MMF assets of €1.6 trillion at the end of 2023.

Historically, banks and other financial institutions filled the roles of market maker and liquidity provider.   But as bank regulations intensified, many market makers took a step back. This created an environment in which secondary market liquidity can quickly disappear, especially considering the reduction in commercial paper outstanding since the global financial crisis and new MMF regulations. MMFs' performance and reputation suffered from that development. A case in point is the "dash for cash" in March 2020 when MMF investors withdrew monies to fulfill other commitments. To meet these redemptions, MMFs turned to previously liquid markets but had significant difficulties in accessing them.

The focus on daily and weekly liquidity increases.   To address situations like the "dash for cash" in March 2020 and increase MMFs' resiliency to market shocks, the U.S. Securities & Exchange Commission (SEC) implemented new measures for U.S. MMFs. Along with a market consultation by the U.K.'s Financial Conduct Authority (FCA), an increase in minimum daily and weekly liquidity requirements has become a top priority. The SEC increased daily liquid asset (DLA) requirements to 25%, from 10%, and weekly liquid asset (WLA) requirements to 50%, from 30%. In comparison, the FCA proposed increasing DLA requirements to 15%, from 10%, and WLA requirements to 50%, from 30%. The changes in DLA and WLA requirements are a direct reaction to MMFs' exposure to potential runs--an increase in unexpected redemptions, typically caused by external shareholders. These runs could affect the stability of the wider financial system.

Decreasing reliance on other counterparties makes sense as MMFs are increasingly seen as a safe haven in times of market stress.   Since the COVID-19 market crisis in March 2020, U.S. MMF assets have increased 49%, while EU MMF assets have grown 28% (see chart 7), embracing their label as a safe haven. The safe haven designation is further enhanced when assessing sterling-denominated MMFs. In the absence of sterling-government MMFs, investors piled £50 billion in sterling prime MMFs--which invest in bank and corporate securities--during the U.K.'s mini-budget crisis in September 2022. Evidence suggests that during the most recent market crises, sterling prime MMFs have performed well, with most flows (64% in 2020 and 51% in 2022) being positive. Notably, we observed that, during September and October 2022, only four of our 105 sterling prime MMF surveillance observations included asset declines of 10%-15% over a weekly period (see chart 8). This suggests existing WLA guidelines were more than sufficient to meet higher redemption levels.

Chart 7

Chart 8

Regulators take further steps to safeguard MMFs.   The envisaged changes have little to do with MMFs' day-to-day prudent, disciplined, and conservative investment activities and more with the realization that MMFs play an increasingly important role in the wider liquidity system and are susceptible to increased redemptions. The success of subsequent regulatory changes should support the short-term money market ecosystem and wider market liquidity.

5 – Which Parts Of The Rating Universe Would Be Most Exposed To A Disorderly Liquidity Withdrawal?

Speculative-grade issuers have been among the largest beneficiaries of cheap and abundant liquidity in recent years. But the overhang of debt from the pandemic era is starting to come into view, with refinancing risk increasing particularly for lower-rated issuers. We think liquidity stress would only exacerbate an already challenging situation for lower-rated issuers.

Constructive if not red-hot primary markets pushed out debt maturities in 2023.   Global non-financials' corporate bond issuance was up 12% in 2023, while that of global financials increased by 2.3% over the same period. Despite this, a meaningful $2 trillion in global corporate debt is still due in 2024, up from $1.8 trillion in 2023. The good news is, however, that approximately 88% of this amount stems from investment-grade issuers, who are less reliant on market timing and can access markets even in times of lower liquidity.

Liquidity stress will be more problematic for lower-rated issuers than investment-grade issuers.   Constructive market conditions in 2023 helped reduce speculative-grade maturities in 2024 by 44%. Only 12% of debt maturities that are due this year are speculative-grade, with non-financial corporate issuers rated 'B-' and below accounting for nearly $60 billion (see chart 9). But debt maturities for issuers rated 'B-' and below will more than double in 2025 and continue to rise through 2028. Prolonged market stress in 2024 would complicate refinancing in 2025 and beyond as issuers typically aim to refinance debt at least 12-18 months before the maturity date.

Chart 9

Liquidity constraints are already a concern, with 31% of potential downgrades in 2023 citing liquidity as a factor.   Financing costs are falling but uncertainty prevails about the speed and amount of rate cuts by major central banks in 2024. Additionally, lower-rated issuers' financing options might be more limited if forecast slower economic growth impairs their operating performance. Liquidity is already a factor in rating actions and it is worth noting that, despite relatively positive current conditions in primary markets, primary issuance by 'CCC' rated entities was almost nonexistent. This is noteworthy since 10% of speculative-grade issuers are rated 'CCC' and below, with the U.S. accounting for roughly 60%.

Sectors such as healthcare could be more exposed to prolonged liquidity stress than others.   The increase in lower-rated refinancing risk in 2024 and beyond mainly results from floating-rate loans and revolving credit facilities, which account for 63% of non-financial corporate debt that is rated at 'B-' and below and matures through 2025. Certain sectors--including healthcare, which accounts for the largest amount of lower-rated maturities (see chart 10)--could face increasing pressure, as the number of issuers with ratings on negative outlook or CreditWatch negative was highest in the healthcare sector in 2023.

Chart 10