Sunday, January 26, 2020

Stock Market Overview -- Global Markets Liquidity Crisis

Stock Market Liquidity Crisis....

September 16th 2019 marked the beginning of the liquidity crisis, within the re-purchasing agreement market, which is short-term borrowing for banks/dealers in government securities -- commonly referred to as the "repo market." This is the way the Federal Reserve injects liquidity into the banking system by purchasing Treasury Bills (non-QE), instead of Treasury Bonds, so that it cannot be referred to as Quantitative Easing or QE4.

The Fed has been in emergency mode, effectively "bailing out" the overnight cash repo markets, continuously. These efforts were supposed to allow banks some breathing room to build up their cash reserves, and resume normal overnight lending, once again, but, unfortunately, this has not happened.

The Fed has intervened almost every night in the repo market, since the rates first spiked out-of-control on September 16, 2019  -- with the fed funds rate jumping, from 1.75% to nearly 10%, due to lack of liquidity -- but nothing has changed since that initial event.

The daily interventions with cash injections have usually been around $75 billion, but despite all of the liquidity the Fed has been providing, it has only served as a Band-Aid, since the problem which caused the spike in the first place has not been resolved.

The rates would spike immediately, if the Fed were to withdraw the overnight cash injections.

There are a few underlying issues causing the liquidity crunch. The main one is the lack of cash reserves at banks. The major players, who usually provide the overnight lending do not have the cash to lend, and the ones that do have the cash are not willing to lend it. Banks' balance sheets are filled with collateral, which are mostly US Treasuries, instead of cash to lend.

The banks have not been able to turn their excess US treasuries into usable cash, despite the Fed increasing its own balance sheet, by essentially providing Quantitative Easing (non-QE). 

This is non-QE, because the Fed is only buying Treasury Bills in an attempt to avoid admitting they are doing QE, which would be the case, if they were buying US Treasury Bonds. 

This has put the biggest banks in a bind, because these big banks are required to buy US treasuries at auction, and now they have no one to sell them to, when they require liquidity.

There is pressure building under the surface, even though it seems the Fed has been able to keep a lid on the repo liquidity issue. Cash and the liquidity needs will increase dramatically, going into the end-of-the-year.

Most people are not aware, but last December 2018, there was a spike in repo rates as well as the year came to a close. 

The difference was that last year banks had much more in excess reserves than they do this year, and didn't have to contend with the restraints that exist this year through the Globally Systemically Important Banks (G-SIB), which is a fancy term for too-big-to-fail banks.

This designation was given to large banks, after the financial crisis, and with the designation comes certain liquidity/reserve requirements, and what banks can do with that money.

One restriction is the order in which banks can deploy any excess reserves that they have on hand. First, banks can lend in repo markets, then, they can use reserves to buy US treasuries. Finally, they can lend through FX swaps (foreign currency markets).

Banks are currently limited to operating in the repo market with only their excess cash, due to their current high G-SIB scores, elevated because of the stock market performance and the flat interest rate yield curve.

It may seem acceptable that the banks are forced to prioritize their repo lending, but the real problem is within the FX swap market, because this will force the FX swap market to be virtually dry of lending. 

The vacuum in the FX swap market will be magnified, with the repo market tapped out. Additionally, just because banks are required to prioritize excess liquidity in the repo market, to begin with, doesn't mean the banks have any liquidity.

In other words, the Fed has placed a lid firmly down on rates in the repo market, and the pressure building is going to burst into the FX swap market.

There will only be one thing that banks and institutions can do, with a massive surge in demand for cash, which would be to sell their assets - US treasuries and equities.

There is a stock market drop, when equities sell- off. The extent of the drop may be insignificant, but it all depends on when the Fed steps in to "rescue" the system, again. It is possible this triggers a larger correction in the stock market in a very short period of time. These things tend to trigger more and more selling like a self-propelling machine, with fast-moving drops.

There is a spike in yields, when US treasuries sell-off, which is disastrous for an economy standing on a foundation of debt. This is because debt service becomes more expensive, and if an economy or country can barely afford the debt as-is, it will collapse, if the debt gets more expensive.

The Fed will attempt to buy US treasuries again through QE4, and turn bank reserves in the cash, which will allow banks to operate as lenders, again. This will also put a floor underneath the sell-off that could get triggered in the year-end liquidity crunch.

The Fed will not start buying US treasuries now, since they have made it very clear that that they don't intend to change their current course until the "incoming data" demands a different course of action.

A looming cash crunch, evidenced by current reserve levels and year-end cash needs, does not count as demanding a different course of action for the Federal Reserve. They have chosen to be reactionary, not proactive, which means that it will likely take a big stock market correction or US treasury sell-off to prompt a change in course.

The big issue here is that the whole system is horribly fragile, and it is incredibly reliant on continuous, increasing debt monetization by the Fed. Every attempt by the Fed to stop, reversed, or slow down this balance sheet expansion has exposed the enormous cracks in the foundation.

The true economic realities will come to the surface, even with ever-increasing intervention/stimulus/accommodation. Printing money solves no fundamental problems, but only delay the consequences. 

The problems grow worse under the surface, with longer delayed consequences. It's simply a matter of time before this deceptive outward appearance breaks.

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