Got Coal?

Got coal?  Investors hoping for a last minute Santa Claus rally got a big fat lump of coal on Tuesday as stocks had their worst Christmas Eve… ever!  Investors were still assessing the damage in the wake of the FOMC meeting last week, when Treasury Secretary Steven Mnuchin decided to let the world know he called all of the major bank CEO’s to check on their liquidity, which according to Mnuchin is good.  He announced that banks “have ample liquidity available for lending”.  The announcement was intended to calm markets but instead it roiled them.  Traders wondered why Mnuchin would be concerned about liquidity.  More on that in a bit.  Let’s turn back to the Fed.  The Fed raised short term rates last week, which was largely expected.  What was not expected was their policy statement that said some more hikes would be needed.  Additionally, Powell in his Q&A session specifically highlighted the necessity for more hikes.  Then there was the dot plot which showed voting FOMC governors’ predictions for Fed Funds in the future.  Those dots show that governors on average believe that rates will be 50 basis points higher next year – that is two hikes assuming they keep going in 25 basis point clips.  Traders were hoping for none – hope is not strategy and bullish traders took heavy losses in the wake of the announcement. Economists, analysts, and geeks like me have been following the Fed balance sheet, which I mention in this note quite often.  Remember Quantitive Easing (QE)?  In the wake of the financial crisis the Federal reserve bought securities to shore up the market and provide a backstop for investors which had an easing effect on the markets because when the Fed buys securities it feeds money into the economy.  Remember the taper tantrum?  In 2013, the Fed announced that it would slowly start to taper its purchases of assets winding down QE.  Markets reacted in a pronounced selloff.  With the crisis behind us a healthy economy emerged and the Fed began the process of normalizing rates and its balance sheet.  That means raising rates and selling assets and they have been doing just that, to the tune of half a trillion since its high in 2014.  What has escaped many traders is that the balance sheet reduction has continued quietly applying the brakes in the background.  In a second wave of analysis traders began to focus on this late last week into Tuesday when the discussion crescendoed adding to the selling.  Now back to liquidity and what it really means.  It is, after all, geek-out Wednesday so lets talk about liquidity, what it means, and why we should care.

There are two types of liquidity that concern investors.  One refers to the availability of cash and the other refers to market liquidity.  Let’s start with cash availability.  When Steve Mnuchin called CEOs of the top six US banks to check on liquidity, he was referring to their ability to make loans. Banks provide significant capital to corporations through direct loans and by purchasing commercial paper.  Commercial paper is unsecured short term debt used by many corporations to provide short term capital for projects and working capital.  Banks also provide significant capital to individuals through consumer loans like mortgages and auto loans.  Remember that consumer purchases and business investment make up roughly 80% of the GDP and if activity by these two aggregates and is hindered in any way, economic growth is impeded (see last weeks geek-out Wednesday on GDP here: ).  in 2007 as the financial crisis was just beginning to take hold, banks faced with the prospect of rapidly defaulting sub prime mortgages significantly cut back on lending. They had no money to lend!  Additionally, Lehman Brothers was on it way out which caused commercial paper markets to freeze due to a loss of confidence. This had a domino effect on money markets funds who hold significant amounts of commercial paper as well.  You may recall that some riskier money market funds “broke the buck” during that time.  Breaking the buck means that the NAV of a fund goes below $1 and investors lose money in what is expected to be the most liquid and safest asset besides cash.  The result was a liquidity crisis, which is still fresh enough in the minds of those of us who were around during that time.  Another type of liquidity is market liquidity which refers to the ability of buyers and sellers of securities to readily find counter parties.  An example of an illiquid market might be the market for high end fine art.  Fine art as an investment is typically limited to high net worth investors and is subject to individual tastes.  If one wants to sell a rare painting, buyers may be limited to not only those individuals who can afford the art but also those who prefer the artist.  An example of liquid market is the large cap stock market.  These stocks tend to feature high volumes with many interested buyers and sellers.  This results in the spread between bid and ask price being close.  The tight spread enables investors to move in and out of securities efficiently.  In contrast, the bond market has experienced diminished liquidity since the financial crisis.  Why is this a concern to investors?  If an investor wishes to buy a bond in an illiquid market they will most likely pay too much for the security which lowers their yield to maturity.  If an investor wants to sell bonds in an illiquid market, they would most likely have to sell at a discount.  Worse yet, an investor may not even be able to sell if markets become volatile. This is a challenge for bond investors because bond markets become highly illiquid during times of crisis.  Panic selling in an illiquid market accentuates downward moves.  This is of particular worry to corporate and municipal bond investors because, like the fine art example, buyers are limited by funds and specific tastes (for names, features, call provisions, etc).  The most liquid bonds are treasury bonds.  The liquidity of the treasury market is maintained by a handful of primary dealers who buy directly from the Treasury, Fed, and non-dealer investors.  Primary dealers have been under pressure by not only increased regulation but also the overwhelming supply of treasury bonds being issued to finance last years tax package.  Market liquidity is critical to ensure orderly movement of assets and funds.  So now you know why investors get a little nervous when they hear the word “liquidity”.

Today we get the Case-Shiller home price index and it is expected to show a year over year growth of +4.8% versus last month’s +5.15% reading.  We are in the final days of the trading year so there will be much discussion on what happened this past year especially considering that the S&P500 is just a hair above bear market territory.  Remember that a bear market is when an index closes more than 20% from its recent high close.  More discussion on the government shutdown, the Fed, and liquidity is bound to continue to inject volatility into trading.  Please call me if you have any questions.

daily chartbook 2018-12-26

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