Will There Be Liquidity Problems in The Equity Markets?

It seems everyone has an opinion about the important things in life, and often those opinions don’t line up with reality. Some “experts” would have you believe that things are fine and dandy, and we are on a solid road to a bright future.

Cem Karsan of Kai Volatility Advisors told Maggie Lake on Real Vision, “By most estimations . . . we’re going to have to issue $1.4 trillion in debt before the end of the year. That is a massive sucking sound out of asset markets.

“There’s got to be buyers of that debt,” Karsan said, stating the obvious, “which means that money is going to come from somewhere. And if that means interest rates go higher, as that supply comes on the market, demand has to be met. That means equity markets or somewhere else, some other risk asset has to reduce liquidity.”

Another expressing concern about liquidity is Eurodollar University‘s Jeff Snider who says those who think the Fed is just printing money are missing the real story . . .

“Nobody ever stops and thinks about what are these bank reserves and what do they actually do? Are they actually a form of base money? And the answer is no. And they haven’t been in decades. In fact, this was a major problem that Paul Volcker confronted in the late 1970s and early 1980s. Banks had found different ways of doing money in liquidity that didn’t involve these bank reserves”.

The hyperfocus on the size of the Fed’s balance sheet and in turn that its increase obviously means more money has been created is wrong, says Snider, who points out that people don’t see the money destroyed in the shadow system. He also points out that it’s not the amount of the money stock that’s important but the circulation of money and credit in the real economy.

This year money is leaving the banking system and not returning. According to Reuters, “The FDIC said the $472 billion in deposit outflows in the first quarter was the largest it had recorded since it began collecting such data in 1984.” This deposit exodus in search of higher yields likely continued in the second quarter.

Many people believe that the Federal Reserve's money printing activities, which have been especially rampant in 2008, 2009, and the years from 2020 to 2023, are highly inflationary. However, it is crucial to acknowledge that these actions have resulted in more deflation in the monetary system than the inflation they have caused via the creation of bank reserves.

As Snider explains, banks, which should be engaging in intermediation and money creation, have been neglecting these roles since 2008. Instead, banks have chosen to secure the most liquid and safe assets, aiming to accumulate profits in small increments. The motivation behind this strategy lies in the anticipation of future liquidity issues that would necessitate prioritizing safety and liquidity over risk-taking.

In layman's terms, it's apparent that banks have not been creating adequate money. Murray Rothbard, in his work "The Mystery of Banking," describes how banks make money. He explains that banks generate money by lending to individuals and businesses, and not by merely hoarding money at the Federal Reserve's reverse repo facility. Interestingly, the balances at this facility have grown from zero in March 2021 to over $2.1 trillion today, yielding a 4.3 percent return.

Snider's observations may evoke memories of the 2008 financial crisis. He contends that this crisis was not solely about subprime mortgages, but that was where it originated. As the crisis began to affect key functions in the banking system, it led to the current situation where money does not circulate freely throughout the global Eurodollar system, causing various problems. Similarly, declining commercial real estate prices are causing disruptions in the market, resulting in liquidity shortages and increased risk aversion. As risk aversion increases, liquidity in these markets diminishes even further.

The Federal Reserve is not expected to rectify this situation. As Snider points out, central banks and the Federal Reserve often fail to anticipate these problems because they tend to focus on past trends rather than future possibilities. Consequently, markets become illiquid, banks struggle to secure funding, and more banks fail. Lyn Alden echoes these concerns, expressing her anxiety over potential liquidity issues. She suggests that the US might face a period of negative liquidity in the near future, following the completion of the Treasury cash drain.

In light of these predictions, it's important for investors to consider factors beyond their stocks' fundamentals.

Fundamentals haven't been the primary driving force behind stock prices for decades, contrary to the narrative often presented by outlets like CNBC.

It's liquidity that truly moves stock prices. Therefore, stock investors should be aware of potential dangers and the possibility of being squeezed out by Uncle Sam. - Douglas French

There Really Is Good News

Corrections can force companies to reevaluate their strategies and operations. This might lead to cost-cutting, debt reduction, or other measures that can improve corporate fundamentals, and thereby enhance the overall health of the equity market.

 
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