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The Era of Easy Money Is Over and Liquidity Is Tightening: What Do You Want to Do?


The smart money is raising liquidity and the dumb money is providing it.

My guess is this is not random, but their models are telling them to sell due to higher discount rates. The cost of debt capital is rising and these institutions are discounting a higher cost of equity capital which translates into a lower multiple. They are selling because of the math.

One of the most consistent themes that arises when I talk to one of my Private Client advisor friends is that their customers are dying for more equity market exposure. The retail propaganda machine on TV is pumping at full throttle and it's tough to filter the noise. The ones who try to be prudent are under significant pressure to be reckless, or worse, are getting fired for not being so. This is because it is so painful to have liquidity. Zero interest rates and QE have driven cash holders to the brink of insanity, and since stocks broke out to new highs, retail is finally capitulating.

GDP growth is slowing, credit growth is slowing, corporate earnings are flat, the bond market is blowing up, the emerging markets have been massacred, the central bank is exiting stimulus, and we have no clue who is going to be the next Fed chairman. This has all developed over the past few months. But these economic and market risks don't compare to what may be coming to a money market near you. In Wednesday's release of the August Fed minutes they dropped a bomb that has garnered scant attention:

In support of the Committee's longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates.

A what?

The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee's ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.

The key term is "wide range of market participants." Who are these participants? Money market funds? Municipalities? General Motors (NYSE:GM) or General Electric (NYSE:GE)? What about Google (NASDAQ:GOOG)?

Veteran trader Kevin Ferry of Cronus Futures, who knows a thing or two about the money markets, characterized the reverse repo facility as The Fed Builds The Death Star:

This nasty beast would attempt to suck up money from massive pools after three years of tri-party reverse repo tinkering proved futile and too risky for JPMorgan (NYSE:JPM) and Mellon (NYSE:BK).

Unlike George Lucas, Ben, and more importantly the Sith Lord to be named soon, cannot start at episode four. But build it they must. After all there's all that "money they printed" out there beyond the moons of Nobu. Spoiler alert – this system seizes up faster than the Millennium Falcon trying to make the jump to light speed.

If there is no liquidity today, what's it going to be like when the Fed, potentially competing with the banking system, is mopping up hundreds of billions in reverse repos? We may not know what this thing will look like, but the bond market has already responded.

Eurodollar Curve

The eurodollar curve for 3-month LIBOR futures, which had already been ransacked by the negative convexity blowout in May and June, is trading like a casino on LSD with dislocations in the curve never seen before. William Naphin, eurodollar trader for ICAP, sent a note out on Thursday titled, "There's simply epic stuff going on in the euro$ curvature today":

It may have quieted in tsys today with a short term range established and vol more or less back to unch (fv still warm), but the money curve is bending hard.

This is not Monopoly money were playing with, Valentine. This market trades trillions. The eurodollar pit is the deepest and most liquid market in the world. Pay attention.

The 5-year Treasury yield took out 1.60% (nearly where the 10-year was in May) while the 30-year rallied, narrowing the spread 15bps on the week. The market is telling you something. The excess liquidity that was a product of QE and has been the support for risk assets for four years is a thing of the past. That great big sucking sound is the Fed's excess liquidity vaporizing. It seems the institutions get this, but retail is oblivious.

From where I'm sitting the markets from Brazil to China to Chicago are saying the same thing. The era of easy money is over, and liquidity is tightening. How this tightening manifests in risk valuation is anyone's guess. The smart money is raising liquidity and the dumb money is providing it. What do you want to do?

Twitter: @exantefactor
No positions in stocks mentioned.
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