Posted February 16, 2022
By Sean Ring
Dr. Liquidity and Mr. Volatility
- Liquidity is draining out of the US Treasury market.
- The S&P futures liquidity is also down, leading to volatility spikes.
- Developments parallel 2008, which was a liquidity crisis first, then a market crash.
London 2008
I first got into financial training in March 2007, a full year after I quit being a futures broker.I wrote a one-sentence letter of resignation in February 2006, and walked out of the office an hour later.For the entire year, I dabbled with writing and traveled around Europe. I also visited my parents at their then-new house in Texas, which was the first time I was ever Deepinthehearta.But once I ran out of bonus funds, I needed to get a job.I landed with a company called 7city Learning, which, unbeknownst to me, was where all the training all-stars worked.It was like walking into the 1927 Yankees locker room and having the men of Murderers Row teaching me how to hit.The boys there were, and still are, the best trainers in the world, though weve scattered to different places.And they taught me everything I know about teaching.Ive never been more grateful or happier working anywhere else, as far as a J.O.B. is concerned.(I dont consider the Rude a J.O.B., by the way!)What amazed me about the teaching process was how they knew how to break any subject into bite-sized pieces so that anyone in the class could understand.Its something I try to do every day in this newsletter, sometimes more successfully than others.The other astonishing thing was how little I knew about my craft, though I had spent ten years in the markets and had two finance degrees.It was like my knowledge was built in one specific area, and as a castle in the sky; I had no real foundation.So I spent my first two years there relearning everything I thought I already knew about finance.And one thing that I learned very quickly was how necessary liquidity was.Liquidity and the Interbank Market
Almost no one knows how the money markets work.And most people dont need to.But when banks were expanding like crazy in the early 2000s, they did it by borrowing money from each other in the form of eurodollars.Quickly: eurodollars dont refer to the currency pair of EURUSD, though we call that eurodollar, too. Market professionals call the pair eurocurrency not to confuse it with eurodollars.So What Are Eurodollars?
Eurodollars are US dollars outside of the United States. And there are far more dollars outside the US than inside.Eurodollars were inadvertently invented by that bastion of capitalism, the Soviet Union.Afraid of the US bank accounts being frozen stateside because they invaded Hungary in 1956, those chess-playing Ruskies used their British-chartered bank, Moscow Narodny Bank, to redeposit their dollars in America.Of course, the US government couldnt shut down a British bank, so the Soviets got to keep their dollars.Smart.The rest of the world cottoned onto the fact that the Federal Reserve couldnt regulate these dollars, and thanks to the Marshall Plan - and higher interest rates paid to creditors for these dollars - the market flourished.London recaptured its crown as the world capital of finance thanks to this.(No, its not New York.)One blog estimates the size of the eurodollar market at $57 trillion.So How Did Banks Fund Their Growth?
Heres a straightforward example.Lets say Apple Corporation is loaded with cash. They decide to deposit $100 million at Lehman Brothers. Lehman is happy to accept the deposit and pay 2% on it.Lets also say Ford Motor Company requires cash, as no one is buying their cars. They need $150 million. Lehman is happy to loan Ford the money, but Ford must pay 3%.Lehman is earning a 1% spread on these transactions, except theres a problem. Lehman is short the $50 million between the deposit and the loan.So Lehman turns to its good friend JP Morgan.Jamie runs JP Morgan, and theyve got loads of dollars.So JP Morgan loans Lehman $50 million @ LIBOR. LIBOR is the London Interbank Offer Rate, the rate banks borrow from each other. (Remember, this is 2008.)Everything is hunky-dory. And everything was fine for the 61 years before 2008, which was when the last money market crisis happened.But then, the markets started to worry about Lehman. Matt King wrote a report now famous on Wall Street for asking, Are the Brokers Broken?The Street assumed he meant Lehman.What happens next is this: JP Morgan and the rest of Wall Street stop lending money to Lehman.Lehman then runs to Daddy - the Fed - to ask for help.The Fed refused, and you know the rest.In essence, the story of 2008 was about liquidity risk creating default risk in the money markets. That contagion crashed the stock market only in the end.But as a futures broker, I never had seen liquidity dry up. It was unheard of. I traded some of the most liquid markets in the world.After Liquidity Goes, Volatility Pops
So while Mom and Pop remember the stock market pooping itself that fateful October, the story started long before.And thats why Im concerned.The boys over at Zero Hedge published a piece about bond market liquidity drying up. The charts that follow all come from that link.If theres one lesson to be learned about crashes, its that the bond markets always warn the equity markets of trouble.Equity investors rarely listen, and thats why they get destroyed every decade or so.Treasury liquidity is down, according to Bloomberg:??
High yield, or junk, bond liquidity is decreasing as well. Of course, that could be both the Fed hiking and liquidity drying up there, too.
And thats having a knock-on effect in the equities market:
Wrap Up
Its just another brick in the wall of information warning you to be careful.Is it all coming apart tomorrow? No.But seeing liquidity dry up is frightening because we now know what usually follows.With fewer players in the market, its easier to see violent swings in asset prices.The problem with always looking at the stock markets is that they are the last to feel the effects.The bond markets are warning us that something wicked this way comes.We should listen to them for a change.Until tomorrow.All the best,SeanThe Kickboxing Economist
Posted April 23, 2024
By Sean Ring
If you care about your...country, read Ludwig von Mises and the six lessons of the Austrian Economic School.
The Price of Empire
Posted April 22, 2024
By Sean Ring
Mike Johnson’s package passed; now Americans are on the hook for another $95 billion.
The Origin Story
Posted April 18, 2024
By Sean Ring
Far from an organized plan, my renunciation was a shock to even me.
Yet Another Sanctions Backfire
Posted April 18, 2024
By Sean Ring
Russia keeps building in the face of failing Western sanctions
It’s Higher For Longer
Posted April 17, 2024
By Sean Ring
Powell slams the door on premature rate cuts.
Steroids For The State - And You’re The Dealer
Posted April 16, 2024
By Sean Ring
You filed a tax return on money you’ve already paid to the government.