Market Thinking

making sense of the narrative

It’s always about cash flow

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The immediate impact of the emergency cut in rates by the Band of England has been to cap sterling’s strength against the $ and compound its recent weakness against the Euro in a race to the bottom on relative cash returns. In the real world 5% in a fortnight might not mean much but to an FX trader it is enormous.

The cut makes sense less on the basis of ‘stimulating lending’ and more in the context of reducing monthly ‘fixed costs’ in so far as they are pegged to base rates. In this sense the BoE is effectively acknowledging the real concerns behind the ‘pause’ in economic activity brought about by the response to the virus, the impact of high debt and operational leverage on free cash flow when activity stalls. Thanks to over a decade of unconventional monetary policy, QE and a system that seemingly incentivises senior management to simultaneously award themselves equity with one hand while raising debt to buy back equity with the other, western corporations have made themselves particularly vulnerable to an economic slowdown.

We saw some of this back in 2008, for all those claiming they ‘forecast’ the crash on the basis of their view on house prices, the reality was that 1) the markets fell the way they did because of excessive leverage and contagion within the markets themselves. In particular, unable to get out of totally illiquid ‘safe’ assets such as CDSs, investors had to liquidate what they could, ie liquid equities. 2) The crisis spread to the real economy because the knock on effect on the Money Market Funds was such that they could not participate in the commercial paper market that had effectively replaced short term bank lending. As such, corporations lost all liquidity and had to resort to dumping inventory, canceling orders and other measures to shore up cash flow.

As such 2008 was really a working capital crisis and the biggest risk right now is that something similar could happen again. That is why the Bank is cutting rates today.

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