Monday, October 15, 2018

Stock Market Overview -- Warning Signals for Markets


Three Early Warning Signs of Declining Liquidity, and the Possible Consequences...

Investors are being lulled into complacency by the illusion of liquidity in good times. Bulls can become Bears, when investors want to reduce their holdings or moved to the sidelines.


Investors mistake is believing that a willing buyer or bank lender will be there for them the moment they want to sell or finance a position. Liquidity may be available, if an investor unwinds a position slowly and early enough, but most investors will stay too long and discovered that when they want to make a move to reduce their position size, everyone else will be doing the same thing, indicating the crash has already started. 

That's one of the hardest parts of investing -- deciding to liquidate positions, when markets are still rising, and the party is still going strong. Investors are overcome with the fear of "missing out" -- they don't want to reduce stock positions and obtain only cash, to find their neighbor is still fully invested and enjoying big gains.

The obvious question for investors is whether it's possible to get a "early warning" or predictive analytical signal that a liquidity crunch is on the way. It would, then, make it possible for investors to stay a little longer with a Bull market, and pick up additional market gains, but still get out in time before the party is over, if such a perfect signal were available.

Right now, indications are that liquidity is growing scarce, and maybe time to sell stocks as well as bonds, and increase cash allocations.

The first indication of liquidity concerns is the narrowing demand in the US treasury auctions. The most important participants are the dealers and brokers, consisting mainly of primary dealers who are obliged by the Fed to bid at auctions and make two-way markets in US government securities.

Overall participation has declined sharply since 2017 in all categories, and dealer participation has steadily eroded since 2012. The primary underwriters of that debt are backing away from the market, as are other market participants, just as the US treasury has to sell record volumes of debt, because of the Trump tax cuts and budget sequester repeal. The result is a sharply falling liquidity in the world's most important securities market.

The second indication that liquidity is drying up is the spread between the London interbank offered rate (LIBOR), and the overnight indexed swap rate (OIS).

An (OIS) transaction is an unsecured contract that involves two banks (or a bank and a customer) in which one party makes a fixed-rate payment and the other party makes a floating-rate payment (the overnight rate).

An OIS transaction mimics the interest rate cash flows on a secured funding, where an investor buys a fixed rate security and finances it in the overnight repo market. The difference in the OIS deals is that there is no actual security involved -- it is just an exchange or "swap" of interest-rate payments, one fixed and the other floating.

The OIS rate is typically tied to the Fed funds, another central bank target rate in Europe or the UK. LIBOR is the rate at which banks lend excess funds to each other for short terms on an unsecured basis.

In principle, LIBOR and the OIS should be almost the same, both are unsecured short-term rates for lending between banks. The difference is that LIBOR is tied to a rate that banks set between themselves, and the OIS rate is tied to a rate central banks control such as Fed funds -- with a typical spread between LIBOR and OIS of 0.10% or 10 basis points (bp).

There is a sign of stress or lack of liquidity in the banking system, when the LIBOR-OIS spread widens beyond about 10 bp. The OIS stays anchored, because it is linked to a central bank target rate, but LIBOR increases because the banks either don't have funds to lend or begin to question the credit worthiness of the counterpart banks.

The LIBOR-OIS spread reached an all-time high of 364 bp (3.64%) at the height of the financial crisis in October 2008. The spread is nowhere near that today, but it has spiked sharply, from 10 bp in late 2017 to almost 60 bp today -- the highest level in over two years. This abrupt change presents a major liquidity concern, going forward.

The third indication is because of the recent Fed announcements that they will be replacing LIBOR with Secure Overnight Financing Rate (SOFR) as a benchmark rate for US dollar-denominated loans and derivatives.

SOFR is essentially the same as the repo rate, which is the rate at which bank dealers finance inventories of government securities on an overnight basis.

LIBOR is being replaced with SOFR, because of the recent scandals in the LIBOR market, involving manipulation as well as price fixing by banks. It is also true that LIBOR is being used less frequently than in the past, because banks have been parking excess reserves at the Fed, so there's less interbank lending on which to price LIBOR.

What the Fed left out of their announcement is the obvious fact that SOFR is a secured rate, while LIBOR is an unsecured rate. SOFR transactions involve pledges of government securities to secure the overnight loans, while LIBOR transactions are totally unsecured loans between banks. SOFR rates will almost always be lower than LIBOR rates, because of the security feature.

The Fed is using a unequal rate comparison to disguise the fact that liquidity is drying up in the unsecured bank lending market. In the future, LIBOR-OIS type spread or LIBOR-repo spread might disappear, because LIBOR itself has disappeared.

This is more than a technical change in benchmark rates, but indications of the coming absence of liquidity in the unsecured bank lending market.

In summary, there are three early warning signals of declining liquidity: Dealers are backing away from the market, private rate-to-Central Bank rate spreads are widening, and the Fed is attempting an unequal switch, to hide lost liquidity in interbank markets.

This may be investors last opportunity to liquidate risky assets, and placed them into more liquid cash positions or setting up a single as well as secure Online brokerage account for global diversity, flexibility, and liquidity, offered through our Private Account Wealth Management Services. There will be a mad dash for liquidity for those investors that wait too long, but won't find it, when they need it the most.

Visit our website at www.wavetechenterprises.com, view the cover page video PowerPoint presentation, click on the "Sign Up" link, and fill out the mentioned inquiry form with your own personalized password as well as answer a few questions, to gain entrance to the over 150 internal pages within the website.


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